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What is the Impact of change in the interest rate on equity investment/share market?

As we know we are the second largest populated country in the world but in a country of more than 138 crore people, only approximately 1.2 crore people (as per data from NSE) actively invest in the share market. When the prevailing interest rate in the market falls, more people tend to see towards the share market for a good returns. Interest rates of banks changes according to the policy repo rate which was reduced to 4% in May 2020. Hence in 2020-21, approx. 81 lakh investor accounts were added.

As we know that investment in the share market is risky hence when the interest rate in the market rises, people avoid risky investments and feel safe by keeping money in bank deposits.

If you are earning 5% interest rate on bank FD and you are in 30% tax bracket then you are earning just 3.5%  (i.e. 5 less 30 % tax), and if retail inflation in the country is assumed 6% then you are not earning anything but losing 2.5% (i.e. 6 less 3.5) every year. Hence before taking your investment decision you need to also consider your return (interest rate) along with your tax rate and inflation rate.

How to find out the break-even rate of return (BER)?

The Break-even rate of return is that rate at which your investment grows at par with inflation and you are not actually earning or losing but keeping pace with inflation. For eg. If you have Rs 1000 which is invested @ 5% p.a. for one year(assume there are nil taxes) and which is to be spent on household commodities having a current price of 100 per item. Assume the inflation rate is also 5%.

If you spend the money today, then the quantity that can be purchased with 1000 = 1000/100 = 10 qty.

After one year your investment become 1050 (with 5% interest) and the prices of commodities also rise to 105 (due to inflation) then after one-year quantity that can be purchased is = 1050/105 = 10 qty.

Hence you are not having any actual gain from your investment, as buying power of your money is the same as it was one year before. Your return is just enough to protect you from inflation. Hence 5% is the break-even rate of return.

You need only two values to find out the break-even rate of return, the Inflation Rate, and your applicable tax rate.

BER = inflation rate / (1-tax rate)

If your applicable tax rate is 30% and assumes the current inflation rate is 9%.

Then Break even rate is = 9 /(1-0.30) = 9/0.70 = 12.86%

A return of 12.86% is not available in bank deposits hence people tend to see toward the share market. A mutual fund can make such a return possible and in case the holding period is more than one year (i.e. more than 365 days) , the tax rate of this investment is also reduced to 10% (that too on gain above Rs. 100000). Hence if money invested in equity mutual fund then Break even rate of return would be –

BER = 9 / (1-0.10) = 9 / 0.90 = 10 %

Now, you can see that interest rate, inflation rate, and tax rate are important enough in making an investment decisions.  

Relation between Interest rate and share market

When the interest rate in the market fall, people can get a cheap loan, (deposit interest rate falls less than BER (break-even rate) and share market shows more than BER) resulting in an increase in money flow in market and share market shows positive charts (except financial sector, which is negatively impacted by a decrease in interest rate).

On another side, if the interest rate rises, loans get costly, resulting decrease in the money supply in the market (further deposit rate rises above/near BER, ) people tend the withdraw money from a riskier investment and like to keep it in safer bank deposits or to repay bank loan which has become costlier. This results in negative charts in the share market (except financial sector, which benefited from an increase in interest rate)

Hence there is a negative relationship between interest rate and the share market if other things remain the same.

Apart from interest rates, tax rates, and inflation, there are many other factors impacting the share market like government policies, international disputes, industrial demand & supply, commodity market, technological developments, financial developments, and international treaties, etc. Above scenario is presented without considering the impact of these other factors. Hence please take the advice of your financial consultant before making any investment decision.

History of changes in repo rate

The chart given below shows the history of changes in repo rate by RBI to control inflation and to achieve the objectives of monetary policy:-

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