Interest rates: Which side of fence are you? - Views on News from Equitymaster

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Interest rates: Which side of fence are you?

Aug 13, 2004

This Tuesday it finally happened. After much dithering, Fed, the US central bank raised the short-term interest rates by one quarter of percentage points for the second time in recent months and hinted that more such steady hikes lay in the months ahead. With economic growth slowing down and job market yet to get fully on its feet, the hike would not have gone well with a section of people. However, the move was aimed largely towards locking the door before the horse of inflation gets bolted. Indeed, rising crude prices have forced consumers to curb spending and has generated inflation led fears. The scenario is no different back home as rise in commodity prices and those of some food items have already taken inflation to 7.5%, a level good enough to infuse some fear. With hike in crude prices yet to be factored in, the level might rise even further in the coming weeks. While, the Reserve Bank of India (RBI) might not have hiked rates just as yet, but the possibility of them doing so is getting stronger by the day. Against this backdrop, we had conducted a poll on our website asking people the following question: ' Have you factored in a hike in interest rates in your investment plan?'

Of the total number of people that polled, 46% said that they have indeed factored in a hike in interest rates in their investment plans while 51% had not done so. 3% had no idea about the same.

Although there are a myriad of investment avenues to choose from, investments could broadly be classified as Debt and Equity investments. Given the dynamics involved, the two are believed to move not in perfect lockstep with each other. On the contrary, historical evidence suggests that there exists inverse relationship between the two. Thus, during a given period while equity investments will lead to higher returns, debt investments might take over after a certain amount of time. Hence, in order to generate superior returns over time, it is important to a keep a check on one's investments and move them accordingly from one portfolio to another. It should be remembered that given the increased integration of the country with the global economy, it has become increasingly difficult to predict changes in the financial markets. It therefore becomes necessary to monitor ones investments frequently and make the necessary allocation. But the question that arises is 'How should one decide which investment avenue is better at the current juncture?'

Although there is no hard and fast rule, in an era of low interest rates, equity investments might well turn out to be the destination of choice for many investors. This is because the low interest rate regime impacts the corporate sector positively in two different ways. Low interest rates enable and entice the consumers into buying more thus leading to a rise in demand. Moreover, it reduces the borrowing cost for corporates and thus helps them in achieving break even faster and also in reducing financial expenses for working capital needs. In short, it is a win-win situation for corporates as it gives a fillip to their earnings and valuations in general. Attractive valuations then result in overall buoyancy in the stock markets. However, this process cannot go on indefinitely as resources such as capital (money and plant and equipment) are only limited in the short run and once a crunch is created, prices of goods might climb leading to excess inflation. Hence in order to curb spending, a hike in interest rates becomes necessary.

No sooner does interest rates begin to rise, bond prices start falling as people start demanding bonds offering high rate of returns in lieu of the current low interest rate bonds. Therefore, in view of the safety that some debt securities offer and also increased volatility of equity markets, some people consider it an opportune time to make investments that are inclined more towards debt markets. Also, the equity markets have to witness certain erosion in prices so as to maintain the relative attractiveness of the equity markets vis-a-vis its debt counterparts. Thus as we have seen, although there is no such thing as 'the' best strategy, adequate diversification can go a long way in shielding you from the market vagaries.

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