DRIVING FORCE BEHIND FINANCIAL MARKET’S MOVEMENT
Ever wondered what makes financial markets move!!! Let me introduce two broad categories of investors, namely, risk-averse and risk-appetite. Risk-averse category of investors are, as the name suggests, averse to risk and they are always ready to sacrifice return inorder to have a safe investment. Risk-appetite category of investors, on the other hand are ready to take risks with an expectation of getting higher returns. The movement of investors between these two categories is all that makes the financial markets move up or down and this movement is based on the continuous flow of facts, figures, events, etc..
Before proceeding further, let me give an example where the Government of India is issuing a 5 year bond (government security) with a yield of 5%. This is a sovereign bond which usually is considered risk-free, meaning investors assume that there will not be any default by the government in servicing coupon and redemption. When the investor gets a risk free return of 5%, would he not expect a higher return in a risky environment, for eg, stock markets? This is one of the reasons why generally stock market moves up when interest rates come down and the vice-versa. When interest rates are brought down, there is a shift from the risk averse category of investors to the risk-appetite category of investors which leads to flow of money in stock markets. This illustrates that interest rates is the fundamental factor for a financial market.
Why does any economy bring down the interest rates? Interest rates are usually determined by Central Banks (like RBI in India). In an economy there are broadly two categories of people, namely, savings oriented and spending oriented. The more one spends the more the prices of goods and services rise and leads to an inflationary environment. This is where Central Banks step in wherein they usually rise interest rates which leads to a shift from spending-oriented category to savings-oriented category on account of higher interest rates, which leads to lesser spending and thus low inflation and the same concept can be used to explain why Central Banks reduce interest rates.
More often than not the above concepts culminate to a probable theme that a falling interest rate environment usually drives the stock markets up and that is what is happening currently in indian stock markets.