How Does The Stock Market Perform When Interest Rates Rise?

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The Central Government has tasked the Reserve Bank of India (RBI) with the job of keeping the Indian economy running as smoothly as possible.

If the RBI believes the economy is lagging, it can cut the repo rate to make borrowing money cheaper for individuals and businesses. This move typically pushes up stock prices, rewarding investors better returns.

The first months of the Covid-19 crisis provide the most recent example of this dynamic. In early 2020, the outbreak of the pandemic drove a shockingly massive and rapid decline in economic activity, attended by the fastest stock market drop in history. The RBI responded by slashing rates as low as they go—and the economy and stocks came storming back.

But what happens to stocks when the RBI raises interest rates?

The Impact of RBI Interest Rate Hikes

When inflation runs too hot or asset bubbles get out of hand, the RBI raises interest rates to cool things off.

Higher rates ripple throughout the entire economy. Mortgages, car loans and business loans become more expensive, slowing down cash flows. This can lead businesses to amend or pause plans for growth.

In the stock market, higher rates can incentivize investors to sell assets and to take profits, especially in times like now when there’s been a few years of double-digit percentage returns on stocks. As you might guess, investor decisions like this can lower stock prices—individually, at least, if not across major market sectors.

What’s more, if interest rates rise high enough, boring savings instruments like savings accounts or fixed deposits might start looking more attractive to some conservative investors.

Do Stock Markets Fall when Interest Rates Rise?

Here’s the thing about the Indian stock market and interest rate hikes. If you try to find data showing a correlation between rising rates and falling markets, you might be disappointed.

The National Stock Exchange recently analyzed Nifty 50 stocks to see what history says about stock market returns in these periods. The analysis—duplicated in the chart below— illustrates that during these long-term periods, the stock market indexes only declined during three rate hike cycles. 

When factored together, the Nifty 50 saw a median increase across all eight cycles of 24.6%. The three calendar years, 2007-2008, 2010-2011, and 2014-2015 had negative returns and five calendar years, 2006-2007, 2008-2009, 2009-2010, 2011-2012, and 2019-2020 had positive returns, all with an average return of 16.1%. 

You don’t have to reach back that far to find evidence that challenges the idea that rising rates lead to falling stocks. In 2014, the repo rate was increased by 25 basis points to 8% and both the S&P BSE Sensex and Nifty 50 hit their lowest level in more than 8-1/2 weeks.

The Dynamics Behind Rate Hikes and Stock Performance

When trying to divine which way the market may move, it’s important to keep in mind that rate hikes don’t hurt everyone equally. In fact, they can help certain sectors, like financial stocks. If you are in the business of lending money, higher rates mean higher margins.

On the other hand, rising rates tend to hurt growth stocks, like tech startups. In uncertain markets, investors tend to look for stable companies, like commodities, indices’ stalwarts and established tech firms.

These companies tend to pay dividends, which insure some growth even if share price drops. High-growth companies usually put their cash into expanding the business, and they tend to churn through cash, so high borrowing costs can really clip their wings.

That’s why difficult markets can favor selective investors—sometimes called “stock pickers”—who happen to guess the right companies and industries to invest in as market conditions change.

But it’s pretty tricky to get the timing right, even for professionals, because not only are you contending with any actions the RBI makes but also those of other investors as well, many of whom have already priced rate hikes into their trading calculations.

But take heart, investors. While the RBI overnight lending rate matters, it is hardly the only thing that impacts stock market returns.

That’s a large part of why experts recommend most people hold diversified portfolios of large index funds. This way, you already have exposure to short-term winners (even if it means you also hold some losers), come what may. And that helps position you to be a winner long term.