Devangshu Datta: The rate effect and why equity market could fall

In an efficient economy, the bond market and the stock market should maintain an inverse relationship. The bond market is driven by interest yields, which are dependent on prevailing interest rates and on traders’ perceptions of future interest rates. 

When interest rates drop, the stock market should rise. This is because the safe return from debt drops. Given low risk-free returns, investors are more prepared to get into risky equity. Also, the real economy tends to respond positively to a lower cost of financing, driving up growth rates. 

Conversely when interest rates rise, the stock market tends to fall. Investors move into debt, given higher risk-free return while the real economy responds negatively to higher cost of financing. Consumption drops, businesses see profits being eroded by higher interest costs and even financial businesses find higher yields offset by lower volumes as credit demand tanks. 

This inverse linkage gets somewhat obscured in a more globalised economy. Given free flow of financing, money can move from regions of low returns to regions of higher returns. But of course, domestic businesses and consumers are impacted by local interest rates, which influences growth. 

For example, high rupee interest rates may inhibit local investors and lead to lower growth prospects. But, if dollar interest rates and returns are low, dollar investors may enter Indian equity anyhow. 

The Indian bond market is small and rigidly controlled and cannot really be called a free or efficient market. A very large proportion of instruments are government bonds, crowding out commercial debt. There is no secondary market to speak of. Investors cannot lay off risks simply by selling since huge discounts to face-value are often required in secondary market sales.

Another more subtle problem arises due to the slow justice system. In theory, a debenture is secured debt, while commercial paper is unsecured debt. If there is default on a debenture, the investor has recourse to legal action to force the corporate to pay up. However, in practice, the legal system is so slow that a corporate could default on its secured debt and the investors would take years to receive payment. This skews the risk assessment.

Nevertheless, despite all the inefficiencies, there is a long-term inverse link between rupee bond yields, interest rates and equity markets. That seems to have been distorted in the last four months by demonetisation and also by a couple of surprises in RBI policy reviews. 

On November 8, before the announcement, the 10-year government bond was trading at 6.81 per cent. By late November, it had dropped to 6.18 per cent. Then the Reserve Bank of India (RBI) imposed special controls and in December, RBI surprised by holding interest rates steady when the consensus expectation was rate cuts. 

The yield rose to 6.61 per cent by late December before falling in January as traders looked for a rate cut in the February policy review. In early February, RBI surprised again by holding status quo. By early February, before the review, the yield had risen to 6.41 per cent. The 10-year bond is now trading at 6.89 per cent - that is, it is higher than pre-demonetisation.

If the inverse relationship had held, the stock market would have soared during November-December and to drop as the yield started rising again in February. In fact, the exact opposite happened. The market crashed in November-December and it has rallied continuously through 2017. 

Interest rate trends are more predictable than equity movements. Consensus suggests that another rate cut isn't likely until the second-half of 2017-18, given the trend in RBI policy and somewhat hawkish minutes of the MPC. If that is so, the inverse relationship could come into force again. If it does, the equity market would fall.

The author is a technical and equity analyst

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