InvestorQ : How will the monetary policy actually impact various investment instruments like equity, debt, mutual funds etc and is it really important?
Arti Chavan made post

How will the monetary policy actually impact various investment instruments like equity, debt, mutual funds etc and is it really important?

2 years ago

There are multiple ways in which the credit policy will impact the investments in the economy. Let us look at some key highlights.

Credit Policy and its impact on your household finances

The one factor that really impacts a normal household is the inflation number. Typically, the inflation shows the extent of price rise in the economy. A high inflation is considered to be negative for households and a low inflation is considered to be positive. Within the ambit of inflation, it is food inflation that matters the most. If the credit policy hints at higher food inflation, it is likely to hit the household budgets hardest. Inflation also has implications for interest rates as a lower inflation will spur the RBI to cut interest lower.

Credit policy and the larger impact on interest rates in the economy

Most likely, you are also keen to understand the interplay of interest rates and credit policy. It needs to be remembered that the credit policy not only signals the direction of interest rates but also actually sets higher or lower interest rates by re-setting the repo accordingly. This is important for a variety of reasons. For a country like India lower interest rates means higher growth and higher economic activity. This means professionals like you will see more economic activity which will directly impact their business. Also a cut in interest rates will mean that the company he is working for can borrow money at lower rates and that is likely to positively impact the performance of his company and consequently his own career prospects too.

Does the credit policy have any implications for equity mutual funds?

Sounds strange but impact there is on equity funds too. Not many people are aware of the relationship between the credit policy announcement and the equity markets. There are 3 key links. Firstly, if the RBI signals lower rates then companies reduce their cost resulting in lower financial costs and higher net profits. This obviously gets reflected in their stock price performance and in the NAV of mutual funds that hold these shares. Secondly, a lower rate signal has a multiplier impact on the economy as a whole as it spurs demand, encourages retail borrowing and also kick-starts economic activity. All this gets reflected in stock prices and therefore on the NAVs of equity mutual funds. Lastly, stocks are valued in the market based on their future earnings. These have to be projected into the future. Now, future earnings are discounted to the present to arrive at a value for the company. This discounting is based on the interest rates. When rates are cut, the discounting happens at a lower rate and therefore the valuation and the stock price moves up. For mutual fund investors like you it adds to your equity mutual fund wealth.

What the credit policy means for debt mutual funds

A debt mutual fund is a mutual fund that invests in bonds issued by the government and by private corporates. There is a negative relation between interest rates and bond prices. That means, when interest rates are cut, the bond prices move up. As a result, mutual funds that hold these bonds also see their NAV going up. Thus lower interest rate creates a wealth effect in debt mutual funds just as it creates a wealth effect in equity mutual funds. For professionals like you, this is great news because they can see their mutual fund portfolios creating wealth without too much effort and risk.

How does the credit policy have an impact on the value of liquid funds?

Liquid funds are also a form of debt fund but they consist of short term debt. Liquid funds invest in treasury bills, commercial paper, certificates of deposit and other debt products with a maturity of less than 1 year. While interest rates are long term signals, these liquid funds are more influenced by liquidity signals given by the RBI. Normally short term rates go up when there is a shortage of liquidity in the money market and go down when there is sufficient liquidity. Over the last 6 months, the RBI has focused more on pushing up liquidity rather than giving rate signals. As a result the surplus liquidity has brought down the short term rates resulting in price appreciation leading to higher NAVs for liquid funds. While these liquid funds are normally preferred by corporates and retired persons, they can be a profitable source for parking short term funds even for professionals like Riaz.