How and why does monetary policy impact equity markets

Monetary policy has become a kind of a routine affair in India every two months. Since monetary policy virtually holds the levers of interest rates and liquidity in the financial system, it does have an impact on markets. So, exactly how does monetary policy affect the stock market? Is there a relationship between monetary policy and stock market? It is hard to pin-point the impact of monetary policy as there are a plethora of other factors that also impact the equity markets.

To gauge this better let us look at the CAGR returns of Nifty and the Bank Nifty since January 2015 when the RBI first embarked on its rate cuts. During this 3 year period, the Nifty has given a CAGR return of 7% while the Bank Nifty has given a CAGR return of 12%. Clearly, the banking and financial sector appears to have outperformed the overall market during a period of interest rate cuts. After all, between Jan 2015 and Jan 2018 the RBI has cut repo rates by 200 basis points. Additionally, there has been an additional 75 basis points reduction in the bank rate due to spread compression. With a total rate cut of 275 bps, financials have been the clear performers in the last 3 years. Remember, this was at a time when PSU banks were in a deep NPA mess and if that had not been the case the outperformance of the Bank Nifty could have been much bigger. Let us understand why is there an impact of monetary policy on stock market in India?

By signalling lower rates, the RBI brings down the cost of capital..

This is a slightly complex argument but offers an important insight into the relationship between monetary policy and stock market trading.Cost of capital has two components viz. cost of debt and cost equity. When we value a stock, we discount future cash flows using the cost of capital. When the interest rates come down, the cost of debt also comes down and that brings the cost of equity down. That means that future cash flows are now being valued with a lower discount rate. Since your stock value is the present value of future cash flows, this enhances the value of the stock. On the other hand, when the RBI signals higher rates, stock values tend to get impacted negatively.

It is a story of rate sensitives and they have a huge weightage..
What are the rate sensitive sectors in any economy? These are the sectors that are typically sensitive to changes in rates of interest in the economy. Sectors like banks, NBFCs, automobile companies and realty companies normally tend to benefit from lower rates. If you add up the total weightage of banks, financials and auto companies in the overall Nifty it comes to nearly 50%. With nearly half of your index companies being strictly interest rate sensitive, the market overall is likely to be impacted by movements in interest rates. More than the actual rate announcements, it is the RBI outlook on rates that is more important in such cases.

Companies are able to reduce their financial risk when rates are cut..
This is a very important factor for the health of Indian corporates. Back in 1995-96 the RBI under Dr. C Rangarajan went on a rate hiking spree to check inflation. That had a major impact on corporate balance sheets as most companies were left with huge levels of debt that were simply not sustainable. When the RBI signals lower rates in its monetary policy, it reduces the cost of borrowing for Indian corporates and brings down their cost of funds. This also reduces the financial risk in their balance sheet and helps improve valuations of these companies in the medium term.

Monetary policy also signals liquidity and that is the key to equity markets..
Back in 2013 when the US Fed indicated for the first time that it would look to taper its bond purchases, there was a massive sell-off globally and even Indian markets were not spared. Equity markets are always wary of a liquidity crunch and it typically leads to a run on equities and a run on the currency. That is exactly what we saw in 2013 when both these factors formed a vicious cycle of market correction. Today global markets are worried that if the central banks of the world start compressing liquidity then global markets will take a hit. In India the domestic liquidity is a function of the RBI monetary policy and RBI usually signals liquidity management through its Open Market Operations (OMOs). Typically, the RBI has tried to keep liquidity in the system comfortable so that markets do not feel the crunch.

Monetary policy of the RBI addresses the twin issues of cost of debt and liquidity; both of which are extremely critical for the health of the equity markets. One of the biggest bull markets in India between 2003 and 2007 was actually driven by a series of easy money policies triggered by the then RBI governor, Dr. Bimal Jalan. That explains it all!

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