Interest Rate Reversal & Market Reaction

Over the course of the year, the RBI has successfully mitigated inflationary pressures, all the while maintaining robust economic growth. Diverging from the trend of rate increases observed in 2022, the year 2023 has been marked by a predominantly stable interest rate environment. Following the Federal Reserve’s surprising decision to maintain interest rates while hinting at possible rate reductions in 2024, taking a more dovish stance, we believe the RBI might consider cutting its rates. How will this transition impact the investors? The report, with historical facts, draws some conclusions 

In the closing month of 2023, the global equity markets surged in unison, marking one of the most impressive performances since 2019. This momentum followed a robust two-month rally, fuelled by investor optimism, predicting a conclusion to the series of interest rate hikes and anticipating swift cuts by major central banks in the upcoming year. The U.S. Federal Reserve’s mid-December policy projections reinforced this trajectory, signalling substantial rate reductions on the horizon. Reflecting this wave of optimism, the MSCI All-Country World Equity Index, encompassing both developed and emerging market equities, soared by 4.7 per cent in December 2023, following a staggering 9.07 per cent surge in November 2023, marking the most remarkable monthly return since 2010. [EasyDNNnews:PaidContentStart]

This bullish surge primarily stems from a drastic shift in interest rate expectations, prompted by recent data indicating a faster-than-expected decline in inflation across Western economies. The prevailing consensus about a steep decrease in borrowing expenses in 2024 has ignited a bond market rally, thereby enticing investors towards equities in pursuit of enhanced returns. Notably, the U.S. 10-year Treasury yield, a key benchmark for global financial assets inversely linked to bond prices, has plummeted to 3.87 per cent from its previous position of over 5 per cent in October, mirroring the continued descent of inflation. 

The market sentiment now anticipates six projected rate cuts by both the Federal Reserve and the European Central Bank by the close of 2024, which is a stark reversal from prior apprehensions of enduring elevated rates. The Indian equity market performed even better. The Nifty 500, encompassing Large-Cap, Mid-Cap and Small-Cap stocks, gained by 15.07 per cent in the last two months of 2023. In addition to the trigger by the U.S. Federal Reserve, the Indian equity market had its own idiosyncratic triggers. First, it was the better than expected GDP growth numbers and secondly, it was favourable state elections. Both these factors helped the Indian equity market outperform many other equity markets.

Interest Rate Cycle and Market Reaction

Even in the domestic economy, we believe we are at the peak of the rate cycle. Inflation measures by the CPI have already reached within the inflation target band of the central bank i.e. 2-6 per cent. Hence, we may see a period of moderate and stable interest rates in the Indian economy, which will likely support economic activity. Interest rates in India have merely returned to their pre-pandemic levels despite sharp increases in policy rates by the RBI over the past 1.75 years. India’s policy rates are at the pre-pandemic levels unlike in the developed markets where policy rates are much higher than the prepandemic levels. Therefore, we believe that as the developed markets’ central banks start reducing their key policy rates, it will give the central bank in India the required leeway to cut rates too. 

The reason they could not do so now in isolation is that it will impact the domestic currency, adversely leading to other macro-economic challenges. As we are a net importer and have current account deficit, depreciating currency will impact us negatively. Regardless of when the rate cut starts, the more salient question is how the equity markets will react to the lowering of the interest rate cycle. The most common wisdom says that the stock market will perform well once the central banks around the world start cutting interest rates. History tells us this is not necessarily always the case. Analysing the market’s response to previous interest rate cuts and comprehending the subsequent sectoral performance is crucial for identifying potential opportunities in the upcoming period. 

The following chart shows the relationship between the Sensex movement and the key policy rate cuts since 2000. 

Pre and Post-Interest Rate Cut Trends

The equity markets encountered significant crisis in the years 2000, 2008, 2015 and 2020, stemming from events such as the dotcom bubble burst, the U.S. bear market, the Chinese stock market crash and the global recession caused by the corona virus pandemic and associated lockdowns. The mentioned events triggered a domino effect on investor confidence, resulting in significant sell-offs across the equity markets. These crises were frequently accompanied by economic contractions, financial uncertainties, and, in certain instances, policy interventions aimed at stabilising both the markets and the broader economy. 

In the event of a crisis contributing to a wider global economic downturn, central banks might collaborate to invigorate the economy. Following a crisis, the reduction of interest rates can serve as a strategy to alleviate deflationary pressures and maintain inflation within the targeted range. Lower interest rates have the potential to stimulate increased lending by encouraging banks to offer loans at reduced borrowing costs for financial institutions. This, in turn, can enhance credit availability in the economy, providing support to both businesses and consumers. 

The aim of the RBI, in reducing the cost of borrowing, is to promote investment, spending, and borrowing among businesses and individuals, ultimately contributing to a boost in overall economic growth. During the mentioned crisis, the stock market experienced substantial double-digit declines, and the impact was evident across various sectors. Analysing the data focusing on the performance of various sectoral indices three months before the interest rate cut, we find that all the sectoral indices displayed a significant downturn over multiple years, reflecting the deteriorated overall market conditions. 

Within six months following the interest rate cut event in 2020, the indices not only recovered from their previous losses but also achieved notable gains. Particularly noteworthy were BSE Information Technology index and BSE Auto index, which surged by 56 per cent and 55 per cent, respectively, during this period. During the one-year period following the interest rate cut, all the major sectoral indices exhibited robust momentum, providing exceptional returns to investors. The BSE Information Technology index experienced a remarkable surge of over 100 per cent, while the BSE Auto index and BSE Realty index climbed by 96 per cent and 84 per cent, respectively. In the following paragraphs, we will deep dive into each period to give you a clear picture of what to expect from the equity market in terms of returns. 

First Rate Cut and Three Months Prior Returns

To get a better understanding of how the first cut in policy rates impact the stock market, we conducted a historical analysis of rate cuts and stock market movement and its different constituents. In fact, over the past seven initial policy rate cuts starting year 2000, more than half of the RBI’s first cuts were preceded by declines in the S&P BSE 500 index ranging from 18.74 per cent to 29.4 per cent. The technology bubble in the early 2000s, the great financial crisis in 2008 and, most recently, the corona virus pandemic proved to be the worst scenarios. Over the past seven interest rate cuts, the S&P BSE 500 index had an average decline of 12.5 per cent between the first rate cut and three months prior to that.

In a normal scenario with no economic or other problems, various indices have done well. A case in point is the rate cut at the start of January 2015. Three months prior to the rate cut till the first rate cut, on an average, different indices have gained by 5.23 per cent. Similarly, during February 2019, different indices, on an average, gained by 2.3 per cent. The metal index was the only one that remained a consistent loser amidst an otherwise better performance by other sectoral and different market-cap indices.

Rate Cut and Six Months after Returns

The returns of various equity indices in the six months following the RBI’s initial rate hike exhibit diverse performances and there is no clear trend. Indices such as the S&P BSE 100, 500, small-cap and mid-cap generally depicted negative returns, punctuated occasionally by instances of positivity, as seen in specific occasion after the pandemic. The S&P BSE Oil and Gas index displayed better performance, showcasing majority of time positive movements. Additionally, indices like the S&P BSE Sensex and Teck portray varied movements but predominantly tend toward negative returns. 

Conversely, the S&P BSE metal and consumer durables indices showcase mixed performances, featuring both positive and negative returns. Amidst this mix, the average returns across all indices tend to be marginally positive, suggesting a positive response to the rate hike. The data underscores the intricate reactions of distinct equity segments to monetary policy changes, reflecting market volatility and sector-specific dynamics.

Rate Cut and One Year after Returns

On an average, the year following the first rate hike by the RBI posted positive returns across different equity indices. Indices such as S&P BSE 100 and 500 initially displayed substantial negative returns, with significant declines in value. However, this trend shifted in the subsequent periods. Notably, the indices exhibited a striking recovery, showcasing remarkable positive returns after the initial downturn. Instances like the years 2008 and 2020 stand out, with indices like S&P BSE metal and small-cap displaying substantial growth, far surpassing their initial negative performances. 

While certain indices like oil and gas and consumer durables demonstrated less impressive recoveries, the average returns across all indices highlight an upward trajectory, indicating an overall positive trend. The average returns, standing at 6.93 per cent to 51.44 per cent across various indices, depict a considerable rebound from the initial losses. This highlights the resilience of the market post a rate hike, displaying the capacity to recover and thrive over a one-year horizon, despite initial market turbulence. 

Impact of Rate Cuts on Different Key Sectors 

Banking, Financial Services and Insurance (BFSI) Sector — A decline in lending rates can exert pressure on the banks’ profit margins, impacting their overall profitability. Nevertheless, the lower rates can stimulate borrowing and increase demand for loans, thereby providing support to the broader financial sector. In a low-interest rate environment, insurance companies may encounter challenges as their investment returns may be impacted. Nonetheless, the heightened economic activity can stimulate demand for insurance products. Those depending on interest income from savings accounts or fixed-income investments may encounter diminished returns. The decline in interest rates can result in lower yields on these investments. 

Consumer Spending and Retail Sector — Lower interest rates typically serve as an incentive for increased consumer spending by reducing the cost of borrowing. Lower interest rates can result in reduced interest burden, potentially freeing up more disposable income for consumers. It can contribute to heightened consumer confidence. When consumers perceive a favourable economic environment due to lower interest rates, they are more likely to spend on discretionary items, thereby boosting retail sales. Retailers across various sectors, such as clothing, electronics, and home goods, may witness an uptick in demand. 

In addition, it can incentivise consumers to make significant purchases, such as cars, thereby contributing to the wellbeing of the automotive industry. It can also contribute to increased affordability of FMCG products for consumers. This has the potential to have a positive effect on the FMCG sector, which heavily depends on consistent consumer demand for everyday products. It could result in sustained or heightened sales of essential goods like food, beverages, personal care items, and household products. 

Real Estate and Construction Sector — Reduced interest rates frequently act as a catalyst for the real estate sector. More affordable mortgages can amplify housing demand, resulting in heightened property sales and the potential for increased property prices. It can have a positive impact on the commercial real estate sector by lowering borrowing costs for businesses seeking to expand or invest in properties. Real Estate Investment Trusts (REITs), which frequently carry substantial debt, stand to benefit from lower interest rate as it decreases their borrowing costs. 

Moreover, the relative appeal of real estate investments may rise in comparison to fixed-income options. Lower financing costs make it more appealing for businesses to engage in new projects, fostering increased investment in the construction sector. On a cautionary note, a prolonged period of low-interest rates may give rise to concerns about an overheated real estate market, potentially leading to speculative behaviour and inflated property prices. 

Information Technology Sector

Domestic IT majors have recently witnessed a robust rally on the back of increased optimism stemming from the Federal Reserve’s decision to maintain interest rates while hinting at possible rate reductions in 2024, as the majority of revenue for these companies is derived from the U.S. markets. Reduced interest rates typically lower the cost of capital for IT companies. This, in turn, enhances their ability to afford investments in research and development, acquire new technologies, and undertake expansion projects. 

In a low-interest-rate environment, mergers and acquisitions activity within the IT sector is often stimulated. The more favourable financing conditions can make it financially viable for companies to pursue acquisitions, fostering industry consolidation and heightened competitiveness. A depreciation of the domestic currency due to lower interest rates can improve the global competitiveness of IT exporters. This, in turn, has the potential to boost international demand for IT services and products. 

Impact of Rate Cuts on Different Capitalisation Tiers

Large-Cap Stocks — Typically, large-cap stocks are perceived as more stable and less responsive to shifts in interest rates when compared to their smaller-cap counterparts. In an environment with low interest rates, large-cap stocks can experience advantages, benefiting from reduced borrowing expenses as companies gain access to more affordable capital for expansion and investment. Investors who prioritise stability and dividends might find large-cap stocks particularly appealing in such low-rate conditions. 

Mid-Cap Stocks — Mid-cap stocks typically demonstrate a more pronounced reaction to economic conditions and shifts in interest rates compared to large-cap counterparts. A reduction in interest rates can have a positive impact on mid-caps, potentially fostering economic growth, given their heightened sensitivity to fluctuations in consumer and business spending. Nevertheless, if rate cuts are interpreted as a response to economic challenges, mid-cap stocks may encounter heightened volatility. 

Small-Cap Stocks — Small-cap stocks usually display a higher level of sensitivity to fluctuations in interest rates and economic conditions. In an environment characterised by low interest rates, small-caps stand to gain from decreased borrowing expenses, potentially resulting in expanded capital spending and business growth. However, in times of economic uncertainty, small-cap stocks may face increased susceptibility to market downturns, and a rate cut might not be adequate to counter broader economic apprehensions. 

Rate Cut Cheer? Wait and See!

Over the course of the year, the RBI has successfully mitigated inflationary pressures, all the while maintaining robust economic growth. Diverging from the trend of rate increases observed in 2022, the year 2023 has been marked by a predominantly stable interest rate environment. Aside from the February policy, in which the RBI implemented a 25 basis points hike in the repo rate to 6.50 per cent, a level upheld in subsequent months, the central bank chose to uphold a steadfast approach by keeping rates unchanged in the subsequent five consecutive policy reviews throughout 2023. 

Following the Federal Reserve’s surprising decision to maintain interest rates while hinting at possible rate reductions in 2024, taking a more dovish stance, we believe the RBI might consider cutting its rates. Against the common wisdom of a rate hike, it will help lift the equity market. Initially, a rate cut does not bring any cheer to the equity market but as the impact of interest rate seeps into the economy, we see improvement in the equity market performance. 

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