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Why do the markets track RBI rates? Understanding the impact of monetary policy on markets

By Finserv MARKETS - Aug 2,2019
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Why do the markets track RBI rates? Understanding the impact of monetary policy on markets

Every two months, the monetary policy committee of the Reserve Bank of India meets to decide on key policy rates. Traders wait with bated breath for the news on rates to trickle out. They vent out their emotions through buying or selling securities and the indexes either plunge or rise. Minutes after the decision of the last monetary policy meet was announced around noon on June 6, Sensex dived 450 points as traders were not enthused by the 25 basis point cut in repo rate. Immediate reactions are largely sentiment driven, but monetary policy also has a deeper impact on the markets.

What is monetary policy?

A central bank has various monetary instruments under its control like altering benchmark rates, changing reserve requirements for banks and Open Market Operations. The way a bank uses these instruments to control the supply of money in an economy is known as monetary policy. The Reserve Bank of India has moved to an inflation-targeting mechanism from 2016 and it manages it primarily through controlling the liquidity in the economy. The bank sets the repo rate, also called the policy rate, after an assessment of the macroeconomic conditions. The change in repo rate transmits to the entire financial system through money markets, which, in turn, determines the demand in the economy. Though the markets are not directly impacted by the change in monetary policy an impact on the larger economy affects all companies.

Why do the markets track RBI rates? Understanding the impact of monetary policy on markets

Rate Sensitive Stocks

Every sector is sensitive to interest rates, in the short term of indirectly in the long run. Consumption in some sectors is, however, overtly dependent on loans provided by banks and interest rate on bank credit moves in tandem with the policy rates. For instance, non-banking financial companies, banks, real estate developers and automobile companies are very sensitive to changes in interest rates. An increase in policy rate can lead to a jump in the rate at which banks lend to the public, and a high-interest rate can slow down consumption. Stocks of NBFCs, banks, and automobiles have nearly 50 percent weightage in the composition of Nifty. It is amply clear that if half of the companies on an index are rate sensitive, the overall market is likely to be impacted by movement in interest rates. The prudent thing to do would be to have a balanced portfolio of rate sensitive and stocks not sensitive to rates. Invest in a mutual fund which has stocks from different sectors, so that the impact of the rate change is contained.

Why do the markets track RBI rates? Understanding the impact of monetary policy on markets

The Cost of Borrowing

With huge operations across states and countries, large corporates need credit to expand and operate seamlessly. If RBI increases the policy rate, banks jack up lending rates, which pushes up the cost of borrowing for a company. If the interest rates are too high it makes corporate debt hard to service and unsustainable. Additionally, it also impacts companies’ growth plans and their competitiveness. If the central bank lowers policy rates or adopts a dovish monetary policy stance, the cost of funds for corporates decreases, which helps in improving the strength of their balance sheets and boosts valuations.

Liquidity

For investors, RBI’s monetary policy provides a signal to the prevailing liquidity conditions in the economy. Nearly all companies are unanimously affected by a crunch in liquidity, so if RBI decides to tighten the liquidity in the economy, the equity markets are likely to fall. After the recent crisis in the Indian non-banking financial sector, the liquidity is already tight as some of the biggest lenders have gone out of the market. RBI has slashed policy rate in the last three consecutive monetary policy meetings with an aim to ease the liquidity crunch and spur growth. In 2013, when the US Federal Reserve had for the first time indicated that it would consider tapering its bond purchases, a signal for liquidity tightening, global as well as Indian markets had witnessed massive sell-offs. The monetary policy of the US Fed also impacts the flow of foreign funds into the Indian markets. If the US central bank increases rates, foreign capital generally flows out of Indian equities.

Conclusion

RBI’s monetary policy is not the only factor that affects the markets. Investors consider many other metrics before buying or selling securities. However, the role of monetary policy cannot be underestimated as it has a deep impact on consumption, which affects nearly all sectors. It is better to have a balanced portfolio to avoid getting trapped in policy-led sell-offs. The impact of monetary policy is not linear and professional fund managers have a better understanding of market movements. It is always safer to invest in a mutual fund and portals like Finserv MARKETS have made it very easy to browse through and choose a suitable mutual fund in accordance with your risk profile.

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