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Interest rates and the stock market

Jun 17, 2004

The impact of rising interest rates has been a hot topic of discussion globally as the US Fed gears for a possible upward revision in the Fed funds rate. The rise in the Fed funds rate may have an impact on countries like India, which till now have been enjoying a soft interest rate regime. The question now to be asked is whether rising interest rates will have any impact on the stock markets. The graph of P/E multiple and 10 year bond yields over the last 50 years has shown certain degree of correlation between P/E multiples and bond yields of G-Secs. Whenever bond prices have gone up, i.e. interest rates have come down, the stock markets have got higher P/E multiple and vice-e-versa. (We have taken Dow Jones data and US treasury data since the US markets are relatively more mature and organized.)

A rise in the interest rates affects the valuation of the stocks. The rise in the interest rates raises the expectations of the markets participants, which demand better returns commensurate with the increased returns on bonds. To substantiate our argument we analyzed the data of last 50 years in the US stock and bonds markets. In our analysis we have found a negative correlation between the P/E ratios of Dow Jones industrial average at the end of every year since 1953 and the 10-year bond yield of the corresponding period. The above relationship of market P/E and 10-year bond Yield of the US treasury gives a very good understanding of, how over the long-term the stock markets are impacted by the change in interest rates.

Moreover, in a low interest rate regime, corporates are able to increase profitability by reducing their interest expenses. However in a rising interest rate regime since interest expenses rise, profitability is hit. That apart, when one calculates the inherent value of a company by the cash flow discounting model, there is a two-fold impact. One, there is a reduction in the cash flows due to lower profitability, second, there is a higher discounting rate due to higher interest rate regime. This leads to a relatively lower intrinsic value of the company.

Due to these reasons there may be a change in asset allocation among equities and debt. Investors who are averse to risk, tend to move funds from one asset class to other. When interest rates rise, investors move from equities to bonds and vice-versa. Having said that it does not mean that all the funds moves from one asset class to another, but it happens that the marginal shift of funds does change valuations to an extent. Whereas when interest rates fall, returns on bonds fall while the returns on equities tends to look relatively more attractive and the migration of fund from bonds to equities takes place, and increasing the prices of equities.

The Fed has already indicated in its review that there will be a rise in the Fed funds rate sooner than later for which, the announcement may come within a month's time. The increase in the Fed rates may impact interest rates in India as well. Infact the UK and Australian central banks have already raised interest rates. The Fed funds rate has fallen drastically over the last four years, and it remains to be seen how the Fed raises the same going forward. In the Indian context, while there may be an impact of rising Fed rates, the same may be muted. While the Reserve Bank of India's response to rising global interest rates may be muted there may be an effect on the yields of long dated government securities, which have shown signs of strengthening in the recent past. Investors need to understand and keep in mind how interest rates and the stock markets are related in order to make informed decisions. While it may be too early to predict the impact of rising interest rates, this aspect deserves due consideration.

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