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Did Market Overreact to the Interest Rate Hike?

It was very much expected and the RBI did it finally! Recently, the RBI hiked the repo rate and reverse repo rates by 25 basis points. For the uninitiated, that means a 0.25% rise. The repo rate (the interest rate at which banks borrow short-term funds from the RBI) is now 6.5%, and the reverse repo rate (the interest rate that banks receive for parking short-term funds with the RBI) is now 5.5%. Two other rates – the CRR and SLR – have been left unchanged.

Why was the interest rate hike expected? Primarily because core inflation (non-food) has been rising and 6 rate hikes in 2010 had little effect in cooling off prices. It’s been a matter of mass debate that food inflation has almost gone out of control, and the Indian housewife is at her wit’s end trying to put nutritious food on the table within the family budget.

If 6 previous rate hikes haven’t managed to control inflation, will the 7th (1st in 2011) fare any better? That is a good question, and the RBI Governor knows it. He took pains to explain to the media that his choices were limited. Inflation needs to be controlled, otherwise high prices of essential commodities will increase input costs for India, Inc. That would affect bottom lines and may slow down expansion and capital expenditure. The severe crack in Hindustan Unilever’s stock price (on 25th of January 2011) is a clear example of investor nervousness. Not only HUL, but the entire market seems to follow the correction mode.

The immediate impact of raising interest costs too much at one go would be resulting in increase of borrowing costs and it might hurt the growth prospects of Indian companies. The RBI has chosen the middle path of a gradual increase in interest rates. If inflation continues to rise, another round of rate hikes may be inevitable (So, be prepared!!). Already, the RBI Governor has relaxed the target core inflation rate to 7% from the earlier 5.5%. There lies the first clue to the market’s fall today. So far, the RBI and finance ministry officials have been making positive noises about controlling inflation through monetary measures coupled with the ‘base effect’ of higher inflation in the year gone by. This was the first official admission that things haven’t worked and aren’t going to work (at least in very near future) as planned.

The second point worth noting here is the unambiguous message that the RBI Governor sent to the commercial banks: Curb lending and increase deposit rates. That may be music to the ears of retirees who stay far away from the stock market and depend on fixed income avenues. Fixed deposit rates at banks will hit the double-digit mark soon. What is meat for retirees is poison for stock market investors. The combination of higher interest rate with lending curbs will throw a spanner in the works of India’s growth story.

Rate-sensitive stocks took a beating today, and don’t be surprised if the stock market cracks further after the Republic Day holiday. As small investors, there are a couple of things they should adopt as their actions.

(i) Don’t panic and sell off everything. But if you are in profit in second rung stocks, book some or all of it.

(ii) Prepare for a bigger correction by making a list of fundamentally strong stocks that offer some Margin of Safety. Let the correction play out.

The next positive trigger may come when the Union Budget will be put forth on the Parliament table. Be alert of your emotions, if possible buy then..

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