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Interest rates - what lies ahead?

Jul 11, 2011

The Reserve Bank of India (RBI) has been raising rates in order to control inflation, and reduce demand. But, this has so far not taken complete effect, and recent inflation numbers are still far from encouraging. However, with the latest 0.25% rate hike, expectations are that this time economic growth may see a slowdown. The RBI recognises this fact, and it is thus expected that the central bank may take it easy on further interest rate hikes once inflation stabilises. Transmission of the central bank's monetary policy has also been strong lately, with most banks raising their base lending rates in response to policy tightening. But, the 'fuel factor' in the economy is the point to watch. Fuel prices including that of politically sensitive fuels like diesel and cooking gas (LPG) were hiked recently. There may soon be a further spike in the inflation numbers before they eventually subside. The big question that remains is whether the central bank will raise interest rates to account for this temporary blip, or will it maintain status quo at its next meeting.

What should investors do?

The point where yield curves invert is usually a point for investors to take stock of what is happening around them. Interest rates have a significant impact on the business cycle. Once rates are hiked dramatically, growth sees a slowdown. It is thus not a good time for companies to take on additional borrowings, as rates are currently high. They should rather wait until rates moderate, for their expansion plans. Floating interest rate borrowers, especially, may see some short term pressure, putting pressure on their cash flows.

Credit creation in the country also gets affected. Banks borrow for the short term, and lend for the long term. They make a profit from the spread (difference between the rates). Since long term rates are either higher, or at the same level as short term rates, this spread vanishes, impacting credit growth. Lower credit growth will mean less business for lenders, and possibly stock price corrections.

Source: Yahoo Finance

Brazil, Russia, India and China (BRICs) all reported slower growth in the first quarter of 2011. Their benchmark indices also failed to impress in 2011, as can be seen in the chart above. India however recovered some of its losses over the past month on account of strong inflows from foreign institutional investors (FIIs). But, as we know FIIs are fair weather friends, and as soon as the situation takes a turn for the worse they will be the first to flee.

Is there a slowdown on the cards?

We believe some slowdown is thus definitely on the cards, and this may lead to some more pain for equity investors. Interest rate sensitive products are the first to take a hit. For instance, car sales in June 2011 rose by a mere 1.6%. In contrast, auto sales in India for the financial year 2010-11 rose a buoyant 30%. The Society of Indian Automobile Manufacturers (SIAM) also expects car sales to grow by 11-13% in FY12, less than half of the growth figure last year. This has been reduced from the earlier expectation of a 16% growth in domestic car sales. Credit growth and housing etc are also expected to take a hit.

The RBI is expecting growth to slow down from 8.5% last year, to 8%. On the bright side, we may at least see some respite from inflation, with this projected to come down to a more comfortable 6% from 9% currently.
Globally also the situation is still not very encouraging, but this may have some positive effects. The Euro zone is still in a hot mess, and US has been reporting less than stellar economic data. A global slowdown will however reduce the demand for commodities and oil, and if these prices moderate, we may see inflation levels subside soon. But even if inflation subsidies, we have still not received any signs from the central bank that the monetary tightening will be reversed.

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