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Relationship Between Interest Rates and NEPSE; Why Do Stock Exchanges Gain Irrationally During Economic Hardships?

I am a momentum swing trader. I never look up company fundamentals or performance reports.

As a momentum stock trader, it is my belief that all market sentiment and trend direction is distilled in the chart itself. Thus, technical analysis has a way to show market insights to a careful observer and a watchful eye.

However, some macroeconomic constraints have a tendency to bring sudden change in investor sentiment and trend direction. Interest rates is one such constraint.

The Relationship Between Interest Rates and the Stock Market

When banks and financial institutions reduce their interest rates on savings, depositors get lesser returns on the amount that they keep under savings accounts.

Thus, depositors are less likely to keep their capital in savings accounts in an interest rates decline. Hopeful that they will get more returns on the stock market, these depositors will channel their money into the stock market. This causes an increase in demand for shares. When any product has higher demand but lower supply, eager buyers offer more for the same product. This is also true for stocks. As a result, stock prices go up when interest rates hit lows.

Furthermore, since the base rate itself is low, banks give margin loans and loans against shares at a lower interest rate. Investors direct the borrowed money to the stock market itself which creates higher demand and a domino effect of rising stock prices.

The reverse process happens when interest rates are rising. The general puplic is more comfortable with the idea of depositing their cash in bank, and thus they do not look out for investment alternatives. Furthermore, institutional investors are also happy with keeping their investment in fixed deposits. This does not create any additional demand in the stock market (at least from the interest rates variable), which does not cause a rise in stock prices.

Relationship Between Interest Rates and Liquidity

Now that the relationship between interest rates and the stock market is explained, it is beneficial to know of a primary driver of interest rates. In this case, liquidity is simply the amount of money deposited on banks and financial institutions.

When depositors deposit their money in a bank, the bank does not keep that money idle. It lends the money to those who ask for loans. The bank makes a profit by lending the money to borrowers at a higher interest rate than the interest amount paid to depositors.

Banks model their interest rates in such a way that they remain profitable (or at least try to) even in uncertain economic conditions. Because of whatever reason, if a bank only receives deposits from depositors but fails to forward loans to borrowers, it has to incur losses. This is because it is forced to keep the money idle while paying annual interest payments to depositors. This may happen when the country as a whole is going through economic hardships, which slows down spending, which then slows down borrowing.

To minimize the losses incurred this way, banks reduce the interest rates. This slashing of interest rates works in the bank’s favor in two ways. First, it now has to pay a smaller percentage of interest payments to depositors, which reduces interest expenses. Second, the lower interest rates attract potential borrowers to borrow from the bank, which helps the bank to get the idle money flowing.

This is also why Stock Exchanges gain irrationally during economic uncertainties

We have already discussed in the previous point that a fall in interest rates deter depositors and they look for investment alternatives like the stock market. Compare that with the relationship between nationwide economic hardship and the decline in interest rates. These two constraints play out together and cause the stock market to rise and even make all-time highs during economic crises. This is why the biggest stock exchanges of the world made all-time highs during the Covid-19 pandemic, and this is also why NEPSE was gaining so aggressively after the earthquake of 2072 B.S.

While this appears illogical to a layman, it is merely a combined result of multiple macroeconomic principles at play.

On the other hand, when very few depositors deposit their money in a bank and there are limited borrowers, banks tend to increase interest rates. This hiking of interest rates works in the bank’s favor in two ways. First, it attracts people to deposit more money in banks, which the bank can then use to lend to borrowers. Second, since the demand for loans is already there, the hike in interest rates won’t deter borrowers to a great extent. Thus, the hike in interest rates only increases the percentage profitability of banks on each loan forwarded.

Disclaimer: No two economic conditions are the same. The constraints that can affect the overall health of financial markets are numerous.

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