Rising interest rates push Sensex down by 400 points

MUMBAI: On Monday, the stock market reported its seventh-largest drop this year. The BSE Sensex fell by 400 points to close at 13,399, raising fears of a rerun of the market meltdown of May and June. Will we see a repeat in December? What has changed between the extreme bullishness of November and early December, and now?

Answer: the interest rate scenario. On Friday, the Reserve Bank of India raised banks’ cash reserve ratio by half-a-percentage point, effectively locking up Rs13,500 crore. As money gets tighter, interest rates have nowhere to go but up.

So why should bulls worry about interest rates? There are several reasons. When interest rates rise, companies end up paying more for their borrowings from banks. This dents profitability — and hence stock price expectations.

But that is not the only damage. When interest rates rise, ordinary investors also start wondering whether keeping money in stocks is riskier than parking it in bank deposits or bonds. If enough investors start asking themselves these questions, money will move from stocks to less risky fixed-interest avenues.

Over the long term, the interest rate and equity market cycles are known to share an inverse relationship. Turn to p20

When long-term interest rates move up continuously, the equity markets tend to look down, and vice-versa.

In India, the markets have been rising since 2003 because of fundamental improvements in corporate profitability and falling interest rates. But since 2004, interest rates have been moving up. Long-term yields (interest rates calculated on market prices) on 10-year government bonds have risen from around 5 per cent in 2004 to 7.5-8 per cent now after touching 8.35 per cent in July 2006.

But the stock market has not stopped rising, driven by higher return expectations on the back of improving corporate profitability. However, on a rising base, returns expectations have sobered down. For instance, as against expectations of 25-30 per cent returns from equities, they are now more sober at 15-20 per cent.

In other words, the equity risk premium has reduced over 2004. Equity risk premium is the excess return that stock market investments are expected to provide over risk-free (or low-risk) instruments like government bonds or bank deposits. For instance, if the market is expected to return 20 per cent and the risk-free rate over the same period is 8 per cent, then the risk premium would be 12 per cent. The gap between the risk-free rate and expected stock market returns is now down. Some investors may be beginning to rebalance their portfolios between stocks and fixed-interest avenues.