The Hindu Business Line : The interest rate-stock price conundrum

In the medium and long term, however, if interest rates keep on rising, it is a definite no-no for stocks. Consumer spending, housing, corporate profits and investment will all be affected. Deviations possible in the short-term

Is increasing interest rates good or bad for stocks? In the US, they say yes, it is bad; in India, the answer is likely to be, if not no, it does not matter much.

So it would seem from the completely opposite reactions to the Fed threat to raise the cost of money and the RBI actually doing so.

The Dow Jones Industrial Average tanked several hundreds of points last week in response to speeches of the Fed Chairman, Mr Ben Bernanke, and his colleagues on the US's interest rate setting body, the Federal Open Market Committee (FOMC), that inflation was a risk and could necessitate tightening monetary policy. Going by the theory that today's stock prices are nothing but future profits discounted at a suitable interest rate (reflecting the risk premium attached to equity investments), when rates go up, ceteris paribus, the discount rate too rises, lowering present values and stock prices. Rates need not really rise; even the prospect of that is enough to cause prices to fall and that is precisely what happened. Markets complied with theory.

What, then, is one to make of the Indian stock market's behaviour after the RBI announced a 25 bps hike last Thursday? The Sensex jumped over 500 points the very next day defying textbooks (and at least immediately putting in doubt the notion that a rate rise is negative for stocks).

Not that the US market is the very epitome of finance theory. There have been numerous occasions in the past when the market ignored the Fed's rate - raising spree and instinct beat logic.

What does emerge clearly is that there could be deviations from obvious correlations between interest rates and stock prices in the very short-term. In the medium and long term, however, if interest rates (do) keep on rising, it is a definite no-no for stocks. Consumer spending, housing, corporate profits and investment will all be affected.

The short-term relationship is influenced significantly by expectations of what a central bank will do and how effective its anti-inflation steps will be. To take the US, the market keenly watches the wording of the FOMC's post-meeting statement to get its take on the economy and price pressures. A positive growth and inflation outlook could overwhelm the negatives stemming from a rate increase.

The lesson for stock investors? Assess what is likely to be the duration of central bank tightening, to what level rates will rise and their impact on business and the economy - in essence what is going to be the interest rate `drag'.

Perhaps Dalal Street's sense now is that corporate profits will trump interest rates - in which case the Friday rally is justified.

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