Why US economy affects Indian stocks!

And your investments too!

There’s a recession all around. US and Europe are facing the worst inflation in history. And in the middle of all this, US Federal Bank is increasing “interest rates”.

So today, we’ll talk about how these interest rate increases (even if it’s just 0.5%) in the US can affect us here in India. I’ll try and explain about interest rates in detail, why they’re hiked, and then talk about their impact on us.

(If you feel you already know a particular topic, you can skip to the next section)

Why does the Central Bank increase interest rates?

Okay, whether it’s the US Federal Bank or India’s RBI - they’re all increasing interest rates (known as Repo rate) right now. But why?

First, what is this “interest rate”?

Simply put, Interest rate (technically known as Repo rate) is the rate at which banks borrow money from RBI. Yeah, banks borrow from RBI too, and the interest rate that they pay to RBI is known as the Repo rate.

How does Repo rate impact any country’s economy?

Well, if the Repo rate is increased, this means that it is more expensive for banks to borrow money. Since there’s an added cost for them, this in turn means that they will also increase the interest that they charge to consumers for loans.

So essentially, borrowing becomes more expensive for people like you and me. This means we will borrow less and eventually also spend less.

Now, I want you to think about this question before you read the next paragraph - Why do central banks increase repo rates in an inflation environment?

If you read the above explanation, you’ll get it right - they do it because they want to bring down inflation. Higher Repo rate means more expensive loans for consumers. This means lesser consumers (and corporations) will borrow money. This in turn will reduce spending.

Lower demand and higher supply will lead to prices of products coming down, resulting in inflation being reduced.

Inflation is the primary reason why central banks increase Repo rates. And that’s why we’re seeing interest rates increasing these days - because the world is struggling with inflation!

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Chalo, now you know how a country’s Repo rate increase can impact that country’s inflation.

But there’s a saying in finance and economics -

If USA sneezes, the world catches a cold.

This essentially means that any economic activity that happens in US, affects the rest of the world.

Now we can’t go into every detail, but I’d like to talk about a few ways in which interest rate changes in the US affect things back home.

Impact of US Repo rate on India

Bonds

There’s an inverse relationship between Repo rate and bond prices (if you want to know how it works, check the link in the “related reads” section) - In a nutshell, whenever Repo rates increase, prices of bonds in the country come down.

Now, a bond pays an interest to the investor, known as a coupon. The coupon is given as a percentage of the face value of the bond. But just like share prices, the price at which you purchase a bond is not its face value. It’s the market value (which is based on factors like demand supply). So if the price of the bond (market value) reduces, the ROI on the bond will increase, because you’re getting the same coupon at a lesser investment price.

Phew! Once you understood this, here’s what happens:

When US Federal Bank increases repo rate, bond prices reduce and ROI on bonds increases. And it’s obvious that investors will want bonds that give a better ROI. So if US bonds offer a better ROI, investors may withdraw their money from Indian bonds and move it to the US bond market. And needless to mention, if there are lesser buyers in Indian bonds, the price of bonds will fall (demand-supply economics), and therefore your portfolio (whether in bonds or in debt funds that invest in bonds) may fall too.

That’s one effect that USA’s interest rate change has on the Indian bond market.

Let’s talk about others.

Dollar and rupee values

Let’s visualize the above scenario, where investors are moving from Indian bonds to US bonds. This also means that more dollars are going out of the country. Now again, the exchange rate is heavily impacted by demand-supply. But since there is no dollar investment coming in Indian bonds, there is lesser supply of foreign exchange, which means the rupee becomes weaker.

So you see, one reason why the rupee is getting weaker and dollar is getting stronger is probably because more dollars are going out of the country. Sitharaman madam wasn’t wrong when she said that it’s the dollar that’s strengthening, not the rupee that’s weakening 😁

And everyone’s favourite - Equity

By now, I’m assuming you’ll be able to understand the impact on equity markets yourself!

So when investors find US bonds lucrative, they may move money from Indian equities too. While bonds offer lesser returns, they’re also safer, and in today’s volatile scenario, many investors would like to play it safe. This means interest rate hikes in US will impact equity markets in India too.

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Okay wait! Before you take investment decisions based on the above information, let me tell you - The above 3 scenarios are taken in isolation. You may sometimes see that US rate hikes don’t make the Indian equity markets move at all. But that’s because US Repo rate isn’t the only variable. There are hundreds of variables that impact a country’s economy, and US rate hike is just one of them.

The idea of this article was to show you some possible impacts that US interest rates have so that you can factor in these things when you make your investments. But please make sure you factor in other aspects too.

But at least now when you read “FPI outflows are impacting the stock market”, you’ll understand what it means.

Hey! If you liked this and learnt something new, why don’t you share it with your friends on WhatsApp and tell them about this newsletter? It would mean a lot to me!

Today’s article was a bit complicated. I just hope I did a decent job in explaining it!

But if I didn’t, please feel free to write back to me with your doubts, and I’ll try and solve them as soon as I can. Also, Substack has a chat feature (on iOS), where you can chat directly with me. Just click on this link, enter the same email ID you use for this newsletter and you’ll see a chat icon where you can message me. This route is much faster! :)

See you next week!

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Related reads

1. How interest rate changes affect bond prices

2. Impact of Repo rate changes on the economy

3. The working of Repo rates - how do banks actually borrow from RBI?

4. What are bonds, and why should you invest in them?