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Effect Of Lower Interest Rates
Lower interest rates make borrowing cheaper which encourages spending and investment. This leads to higher demand for goods and services and boosts economic growth. But, simultaneously it poses a risk for inflationary pressure.
Theoretically, lower interest rates will:
The Depreciation in the exchange rate: If RBI were to reduce interest rates, it would make it relatively less attractive to save money in India (better rate of return available in other countries). This will lower the demand for the Rupee and cause its value to fall.
A fall in the exchange rate makes Indian exports more competitive and imports more expensive. Simultaneously, it also helps increase demand.
Falling interest rates. How does it affect my Investment Portfolio?
Debt and Debt Mutual Funds
Bond prices and interest rates are inversely related. As interest rates fall, the price of bonds rises resulting in an increasing net asset value (NAV). This translates into higher returns for the investor.
The impact felt more on bonds with shorter maturities or schemes that hold them compared to those holding bonds with longer maturities.
What should the investor do?
• Look for bonds with longer maturities from credible issuers (Government, AAA corporates etc)
Stocks and Equity Mutual Funds: Equities
As interest rates falls so does the cost of money. The general public finds ways to increase spending.
This affects the product manufacturers, the service providers. Which are effectively the companies that are listed on the stock exchange. Their earnings will rise or their cost of borrowing might fall resulting in a spike in the stock price and by extension the stock market.
But only over the short term.
What should the investor do?
• Long term investors in equity need not worry. It's a part of every economy and affects a fundamentally strong company temporarily.
Bank fixed deposits
Falling interest rates can for Fixed Deposit investors. If the RBI reduces interest rates the banks are also likely to reduce their FD rates depending on their liquidity, credit status etc.
What should the investor do?
• Lock in your money at the prevailing higher interest rates for a long tenure.
• Make sure you calculate your total return after accounting for inflation and tax
• Look at investing PPFs as well. They offer a fixed interest rate and are tax deductible.
Consider the risks and potential rewards of a variety of assets, and focus on total return. Total return looks at the change in an investment's price, plus stock dividends or bond coupon payments. Regardless of what you chose, make sure you consider your time horizon, your risk-tolerance and your long-term goals.
