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- 📉 Interest Rates Are About To Go Lower
📉 Interest Rates Are About To Go Lower
How will it affect the economy, stocks and you!
Madhu, Altcase
September 21, 2024
Welcome to this week’s Altsights!
➡️ Last Friday, The European Central Bank (ECB) cut interest rates by 0.25%.
➡️ A couple of days ago, The Federal Reserve (US Central Bank) also cut interest rates by 0.50% after more than 4 years!
I am sure you thought ‘So What? Why Should We Care? 🤔’
Rate cuts in other parts of the world, especially in the US, means the RBI may start cutting interest rates in India soon.
This will affect the economy, the stock market and you several ways!
In today’s Altsights, I discuss what happens when interest rates go lower 👇🏼
Table of Contents
How Do Interest Rates Affect The Economy 📊
Interest rate is the cost of borrowing
High interest rates discourage borrowing. This helps reduce inflation but also slow down the economy. Here’s how:
So, Lower Rates Are Better?
A lower interest rate (or lower cost of borrowing) has the exact opposite effect on the economy.
People borrow more, spend more and everyone prospers! 🎉
So, why even keep interest rates high?
Good question!
You see, when the economy is doing really well, it tends to heat up 🔥
A heated economy often leads to high inflation rates because demand for goods and services rises as everyone prospers.
This can lead to inflation that goes out of the government’s and the central bank’s controls - also called runaway inflation.
Without going into the details, let’s just say that runaway inflation is bad - really bad.
High interest rates are implemented by central banks when they see the economy heating up to control inflation rates.
The Toughest Job in The World 😣
You may have realised by now that central banks have not only one of the most important but also probably the toughest job in the world.
📉 Lowering interest rates aggressively results in economic prosperity but may also result in uncontrollable inflation.
📈 Increasing interest rates aggressively results in economic slowdown but may become necessary at times keep inflation in check!
Central banks have to delicately balance economic growth and inflation through their interest rate actions ⚖️
Why Are Central Banks Lowering Interest Rates in 2024? 📉
For most of the world, inflation was the biggest problem of 2022 ⚠
To tackle it, central banks raised interest rates aggressively before inflation went out of control.
While inflation is in control today, the negative effect of high interest rates has now started to manifest across economies, especially the advanced economies.
👉🏼 Recall that economic slowdown is the negative effect of high interest rates.
To support the slowing economy, central banks in these economies have now started to lower interest rates 📉
The expected effect is that lower interest rates will encourage borrowing and spending and result in increased economic activity.
How Do Interest Rates Affect Stocks 📊
This is going to be tricky, so bear with me 🐻
There are two types of learnings we can apply to any situation:
Theoretical - What will happen in theory or on paper
Practical - What will actually happen in the situation
Theoretically, stocks should go up when interest rates are cut because:
The cost of borrowing goes down for companies
Spending increases which results in higher revenues for companies
Fixed income assets become less attractive, making stocks relatively more attractive
But if we look at history, there is no clear relationship between the Federal Reserve’s interest rate actions and Indian stock prices (represented by NIFTY 50).
We don’t know if Indian stocks will rise or fall as a response to the Fed’s interest rate cuts
This doesn’t surprise me because stock prices are a function of many factors. We know and can explain some of them, but have no idea about the others.
My Two Cents On Today’s Stock Prices 🪙🪙
I personally find it impossible to ignore the very high valuations at which Indian stocks trade today.
While there is no relationship between Federal Reserve’s interest rate actions and stock prices in India, there is ample data to establish a relationship between stock valuations and their future returns.
The relationship is simple and has passed the test of time - higher the valuations at which you invest, lower are the future returns.
How Do Interest Rates Affect You 📊
Note: Most of the following will be affected when the RBI actually starts cutting interest rates in India. I think it will start happening before 2024 ends!
Floating Rate Loans: Most home loan interest rates in India are linked to the RBI’s interest rate actions. So, when the RBI reduces interest rates, the interest rates on floating rate loans also goes down.
Fixed Rate Loans: Generally, short-term loans like car loans or personal loans have a fixed interest rate. These will be unaffected by the RBI’s interest rate hikes or cuts.
Fixed deposits: Your existing fixed deposits are not affected by the RBI’s interest rate hikes or cuts. However, the FD rates that had been inching up for many months now have probably peaked. The banks know that the RBI will start cutting rates soon and once that happens banks will start offering lower FD rates.
Bonds: Existing bond prices will go up when interest rates are cut by the RBI. New bond issuances will take place at lower yields. The next few weeks is a good time to lock-in yields of high quality bonds.
Gold: Lower interest rates are better for gold in theory. But just like stocks, gold prices are driven by many factors. So, it is difficult to predict how gold prices will react in the medium term to interest rate cuts.
Hope today’s read helped you grasp the economics of interest rate cuts better.
See you next week!
Cheers,
Madhu,
Founder, Altcase