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Why lower interest rates augur well for equity

Shashikant Singh
/ Categories: Mindshare
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Why lower interest rates augur well for equity

The equity market has gained almost 60 per cent from its lows of March 23. One of the major reasons behind such a recovery was a drastic drop in the interest rate. Reserve Bank of India (RBI) has cut key policy rates by more than 1.15 per cent since the onset of a pandemic. Globally also, the same thing is happening and thus, central banks were swift enough to cut interest rates.

Lower interest rate works in favour of equity for the following reasons:

It stimulates the economy: Once the interest rate is cut, it reduces the finance cost, and hence, it becomes cheaper to buy a house because the monthly mortgage payment is smaller and this applies to every other expense. Corporate interest expense also declines as well. Besides, the fear of missing out on the low rates give customers pre-pond their various expenses.

It increases the discounted present value of future cash flows of companies: The rate at which we discount future cash flows depends on the risk-free rate as well as on the premium that you give to the risks involved in investing in them. Hence, as the risk-free rate goes down and risk premium does not increase, we see asset price moving up, which happened with equities.

Lower returns from debt make equity attractive: No asset class exists in isolation; they are interconnected and hence, money move from one asset class to another, depending upon their attractiveness. Therefore, when fixed-income yields lower rates, investors move their assets towards equity. This is what is going on now.

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