Interest rates: gravity for asset prices

Warren Buffett has likened interest rates to gravity for asset prices. It is the best one-word description you will find, and the whole of this chapter is an attempt to make you feel it in your stomach rather than just nod at it. When gravity is light, things float higher than they should. When gravity strengthens, everything gets heavier — including the stocks in your demat account, even the ones whose business hasn't changed one bit.

What the repo rate actually is

The repo rate is the interest rate at which the Reserve Bank of India lends short-term money to commercial banks against government securities. Think of the RBI as the bank for banks. When HDFC Bank or SBI is short of overnight cash, it can borrow from the RBI — and the repo rate is the price of that borrowing. It is the wholesale price of money in the country.

Because it is the cost of the most basic, safest, shortest borrowing in the system, every other rate in the economy is built on top of it like floors on a foundation. The rate your bank pays you on a fixed deposit, the rate it charges you on a home loan, the yield on a ten-year government bond, the cost at which a company issues debt — are all anchored to the repo rate, stacked around it by risk and time. Move the foundation, and every floor moves with it.

Who decides — the MPC

The repo rate is not set by one person on a whim. It is decided by the Monetary Policy Committee (MPC) — a six-member body, three from the RBI (including the Governor) and three external members appointed by the government. They meet several times a year, look at where inflation and growth are heading, debate, and vote; the decision and the vote split are published, along with the minutes a couple of weeks later. Their formal job is an inflation target: keeping consumer price inflation around a central figure within a tolerance band, set in agreement with the government. That mandate matters because it tells you why they move. The MPC is not trying to make the stock market go up — it is trying to keep prices stable while not strangling growth. When you understand their objective, their decisions stop looking random.

How a rate change ripples outward

Suppose the MPC raises the repo rate. Trace the wave, because following it once is worth more than memorising any definition.

1. 1Banks' cost of funds rises. Borrowing from the RBI just got dearer, and banks compete harder for your deposits, so FD and savings rates drift up too.
2. 2Loan rates rise. Home loans, car loans, business loans — many are linked to an external benchmark tied to the repo rate, so your EMI can move within a quarter or two.
3. 3Bond yields rise. Newly issued bonds must offer more to compete, and existing bond prices fall to make their fixed coupons competitive (more on this in the bonds chapter).
4. 4Borrowing slows, saving rises. Loans cost more, so households and companies borrow and spend a little less; parking money in safe deposits looks a little more attractive.
5. 5Demand cools, and so eventually does inflation. Which was the point all along.

A rate cut runs the same film backwards: cheaper loans, lower deposit rates, rising bond prices, more borrowing and spending, a nudge to growth — and the risk of more inflation if the RBI overdoes it. The repo rate is a single dial wired to the whole economy. That is why a quarter-point move makes the front page.

Why rates are gravity for stocks

Now the part that matters for your portfolio. A share, as we said in Module 1, is a claim on a business's future profits — cash that arrives next year, in five years, in twenty. To know what that future cash is worth today, you mentally shrink it down, because a rupee a decade out is worth less to you than a rupee in your hand now. The number you shrink it by is the discount rate — and the discount rate is built directly on top of interest rates. When rates are low, you barely shrink future profits at all, so far-off cash stays plump and stocks can carry high valuations. When rates rise, you shrink future profits harder, and the same expected cash is suddenly worth less today. Nothing about the business changed. The company sells the same products to the same customers. But the price you'll rationally pay for those future profits fell, because gravity got stronger. That is the whole mechanism, and it is why markets can fall on a rate decision even when corporate earnings are perfectly healthy.

There's a second, subtler reason rates are gravity: they offer competition for your money. When safe FDs and government bonds yield very little, investors are pushed out along the risk curve into stocks to earn a return — there is nowhere else to go. When safe yields rise to a juicy level, some of that money flows back into deposits and bonds, because why take equity risk when a fixed deposit pays handsomely? Every percentage point on the repo rate quietly changes how attractive the entire stock market looks against the boring alternative.

The rate-sensitive sectors

Some sectors live and die by the cost of money, and they move ahead of rate decisions because the market is always anticipating. Learn this list — it explains a lot of seemingly strange days.

• Banks — they borrow at one rate and lend at a higher one; the gap is their margin. Rising rates can fatten or squeeze that margin depending on how fast deposits reprice versus loans. Banks are also a leveraged bet on the whole economy.
• NBFCs (non-bank lenders) — they don't have cheap deposits to fund themselves; they borrow from the market, so their cost of funds tracks rates closely. Higher rates pinch them harder than banks.
• Autos — a huge share of cars and two-wheelers are bought on EMIs. Costlier loans mean costlier EMIs, and demand for the showroom cools.
• Real estate — the most rate-sensitive sector of all. Home loans are the market; when EMIs jump, buyers vanish, and developers carry heavy debt of their own that now costs more to service.

The rate versus the *expectation* of the rate

This is the idea that separates people who understand markets from people who only read the headline, so sit with it. Markets trade the expectation of the rate, not the rate itself. By the time the RBI actually announces a hike, the market has usually spent weeks pricing it in — through economists' forecasts, bond yields, and the tone of the previous meeting. The announcement is often the least interesting moment. What moves markets is the surprise — the gap between what was expected and what happened — and the guidance about what comes next. A hike that everyone expected can be met with a market rally if the RBI's commentary sounds softer than feared; a 'hold' can trigger a fall if the Governor's tone is unexpectedly hawkish about future hikes. The level is old news; the change in expectations is the news.

Hold onto the gravity image as we go. Inflation, the rupee, and foreign flows — the next two chapters — all eventually express themselves through interest rates and the discount on future cash. Rates are the channel the whole macro story flows through to reach the price on your screen.