It appears that the interest-rate cycle is about to turn. Fine-tune your financial strategy to profit from the likely decline in interest rates in the first quarter next year
What spurred the Reserve Bank of India (RBI) to announce a cut in the cash reserve ratio (CRR) on October 6 was the flaring up of rates in the overnight call money market. Subsequently, the RBI revised the CRR rate cut by a further 100 basis points (1 percentage point) on October 10. With inflation at 11.80 per cent, the central bank can?t possibly cut the repo rate. So it has chosen to infuse liquidity through a CRR cut. Some time ago, it had taken another measure designed to infuse liquidity: it had reduced the SLR (statutory liquidity ratio) requirement of banks by one percentage point from 25 per cent to 24 per cent. More such cuts (of CRR and SLR rate) could come on October 24, when the central bank reviews its credit policy.
While central banks all over the world are cutting interest rates, the RBI cannot afford to cut the repo rate at present for several reasons. One, inflation remains high at around 12 per cent. Cutting interest rates now could once again stoke inflationary pressures. Two, the rupee is depreciating sharply: it is down 21.8 per cent against the dollar since the beginning of the year. Reduction in interest rates could cause further outflow of capital, thereby causing the rupee to depreciate more. That is not what the RBI would want, given our massive oil import liabilities.
According to economists, in March 2009, when the base effect turns favourable, inflation is expected to drop off sharply. So the central bank is expected to cut rates between January and April. According to Tushar Poddar, vice president, Asia Economic Research, Goldman Sachs, ?We think that interest rates have peaked and the central bank will start cutting rates in the first quarter of 2009.?
Veer Sardesai, a Pune-based financial planner, however, points out, ?If globally interest-rate cuts are deep, and the differential between global interest rates and India?s becomes substantial, that would give the RBI leeway to cut rates deeper. Otherwise interest-rate cuts in India are likely to be smaller than in the West.?
What is clear is that the interest-rate cycle is about to turn, and that calls for a few adjustments to your financial strategy.
Move to longer-term debt funds
In a rising interest-rate scenario, most investors would have parked the debt component of their portfolio in one of these two types of instruments: liquid funds (where the return is low, but there is little risk to your principal), or in fixed maturity plans (FMPs), which indicate a certain rate of return at the time of investment.
To benefit from the decline in interest rates, investors need to shift their funds to debt funds with longer-term horizon. The value of long-term debt instruments rises more (than that of short-term debt instruments) when interest rates fall. Hence, long-term debt funds? value also appreciates more when interest rates decline.
?While investors should not change their asset allocation between equity and debt, within debt they could change their allocation in favour of longer-tenure debt funds,? says Sardesai.
However, investing in longer-tenure debt funds will involve an element of timing. ?You need to enter these funds before the interest-rate cuts begin and exit them before rates start moving up again. This may not be everyone?s cup of tea,? warns Sardesai.
Ashutosh Wakhare, financial trainer at Nagpur-based Money Bee Institute, suggests an asset allocation that he considers appropriate for the current market. He suggests spreading your debt investments among three types of debt funds: 35 per cent to fixed maturity plans; another 35 per cent to liquid funds, liquid plus funds, and floating-rate funds; and the rest 30 per cent to long-term gilt funds. ?If interest rates have peaked and will head south from here onwards, as appears likely, then this strategy will allow an investor to lock in funds at high interest rates for the long term and at the same time get attractive returns in the short term as well,? says Wakhare.
In case of short-term FMPs, i.e., for periods of less than 12 months, Wakhare suggests the dividend option, and in case of FMPs for the long term (i.e., for a period greater than 12 months), he suggests the growth option.
Postpone loan-based purchases
If interest rates are likely to decline, then the cost of housing and car loans is also likely to fall. If you are planning to purchase these items, it would make sense to wait for a while.
Existing homebuyers, who have taken a floating-rate loan, should also not contemplate shifting to a fixed-rate loan (because of the fear that interest rates could rise higher, and their monthly EMI burden would increase further) since relief appears to be in sight.
Fillip to economy and markets
If interest rates do decline, economic growth is also likely to pick up pace. Such a decline would also help the stock market recover from its present low levels.
Within the stock market, some of the interest-rate sensitive sectors would clearly benefit from the cut in interest rates. Banking and finance sector would be directly benefited: banks would lend more, and their net interest margins would also rise in a falling interest-rate scenario.
Auto and realty are two other sectors whose sales depend heavily on interest rates, since most housing and car purchases today are financed by loans. In case of the realty sector, not just the buyer, even the developer depends heavily on bank loans for funding his project. A decline in interest rates would perk up both these sectors, and would also have a positive impact on their stocks, which have taken a massive beating in recent months against the backdrop of rising interest rates.
Companies with a high level of leverage would also be impacted as their interest-rate burden would come down. This would have a positive impact on their bottom lines.
While the decline in interest rates might appear speculative, this is how the best of investors think and invest. They study the numbers, and if an event appears probable, they position themselves well in advance to benefit from it. After all, that?s what investing is about: investing in high-probability events that might occur in the future based on incomplete information in the present. Are you knowledgeable enough to pull off such a strategy?
