The Stock Market’s Recent Downturn Across the World
Recently, the US Federal Reserve announced the final round of its asset purchases. It will thus conclude its balance sheet expansion in March, much ahead of its initial plan. The Fed will subsequently start to increase interest rates in the economy beginning March. Both these measures are aimed at taming inflation, currently at a four-decade high of around 7%.
GS-III: Indian Economy (Capital Market, Fiscal Policy and Monetary Policy)
Dimensions of the article:
- What do rising interest rates mean?
- Why are stocks falling as interest rates rise?
- What lies ahead?
- Impact on the economy:
What do rising interest rates mean?
Central banks such as the U.S. Federal Reserve, the European Central Bank, the Reserve Bank of India and others constantly influence interest rates by regulating money supply.
When central banks are willing to flood the credit market with plenty of money,
- This causes the overall demand for credit instruments like bonds (which represent a claim over future cash flows) to rise as speculators bid up the price of bonds in the expectation that central banks will lap up these bonds eventually.
- The rise in the price of bonds causes their yields (or interest rates) to fall.
- The U.S. Federal Reserve has also been a major determinant of interest rates in the American mortgage market through its bond purchase programme named quantitative easing.
When central banks, on the other hand, contract money supply,
- This can lead to a fall in liquidity in the credit market and consequently lead to a drop in the speculative demand for bonds and other credit products like short term loans.
- As a result, the prices of these instruments drop and their yields (or interest rates) rise.
Why are stocks falling as interest rates rise?
- Stock prices and bond yields are inversely related. As bond yields rise, stock prices fall; and as bond yields fall, stock prices rise.
- This is because, when interest rates (or yields) on safer investments like bonds fall for instance, more investors would be willing to dabble in stocks.
- For example, if interest rates on bonds were to drop from 5% to 1%, this would persuade investors requiring a minimum return on investment of anything between 1% to 5% to desert bonds and move into stocks in which they hope to make higher returns by assuming greater risk.
- This process basically leads to future cash flows from stocks being discounted at lower rates than before, thus causing stock prices to rise. Conversely, when interest rates rise, this can cause future cash flows from stocks to be discounted at higher rates, causing stock prices to fall as a result.
- So, it is possible that the recent fall in stocks is due to speculators pricing in higher interest rates.
What lies ahead?
- If central banks were to withdraw the support they have offered to credit markets and allow interest rates to rise, this should mean that stock prices will fall.
- However, it should be noted that markets can be overvalued or undervalued when compared to their fundamentals for long stretches of time.
- Further, there are other variables such as earnings expectations that influence stock prices. Stocks may also consolidate at high prices for a long time until earnings catch up to justify the high prices.
- So, at the end of the day, the technical forces of demand and supply may determine trends in stock prices in the short run. At the moment, it seems like the S&P 500 has found some support at the 4,300 level while the Nifty could find further support at 16,600.
Impact on the economy:
- Asian markets have reacted nervously to the decision, with premier indices in Japan and Hong Kong falling 3.15% and 2% respectively, and the benchmark Sensex and Nifty at BSE and NSE too falling by up to 2.4% before recovering to close the day with a fall of 1%.
- Over the last seven trading sessions, the Sensex has lost over 4,000 points or 6.57%
- Rising interest rates can also wreak havoc on the economy as there could be the need for widespread reallocation of goods and services across the economy to adjust to higher interest rates.
- For example, business projects that seemed to make sense when interest rates were low and liquidity was abundant may need to be abandoned in favour of other, more viable projects.
-Source: The Hindu, Indian Express