As the market was expecting, the US Federal Reserve (Fed) increased the short-term interest rate of the world's biggest economy by 25 basis points on Wednesday.

This hike in the US interest rate has happened for the first time in last four years. So, how will this interest rate hike in the United States affect the Indian stock market?

The theories suggest that, when interest rates go up, there is reason to believe that asset prices will go down. The fall in the asset prices occur mainly due to rise in the cost of funds borrowed to buy these assets. As the cost of funds rises, the demand for assets decreases due to postponement of buying decisions.

And vice versa is expected when interest rates fall. The best example to support this argument is the growth witnessed in the Indian home loans with the fall in the interest rates in the recent past.

However, higher interest rates make investment in bonds more lucrative (if held through the maturity) that competes with the other asset classes like equities and real estate.

So, investors who want to play safe can shift part of their funds from equities to debt. To some extent, there can be a decline in stock prices owing to the increased asset allocation towards debt funds. The change in the 10-year benchmark paper yields, in this context, will have to be watched closely.

Just to put things in perspective, yield on 10-year benchmark paper in India has climbed sharply (more than 60 basis in last few months) on the back of expected hike in Indian interest rates.

The graph above shows that over last 50 years, stock markets have shown a strong negative correlation with the interest rates. Just to go back in history, the Nasdaq stock price index gained 14 per cent in a single day (January 3rd 2001) when the Fed cut interest rate cuts. So should we expect the markets to fall sharply now?

To an extent, the interest rate fear has been factored by stocks markets, globally and in India. The question now is what next? If interest rates rise at a faster rate than what the investors are expecting, there is every probability that stock markets could face significant selling pressure. As Ajit Dayal, co-founder and Chairman of Quantum Information Services Limited, puts it: "I personally doubt rates in America will cross 3 per cent in the year 2004, although I believe that they will go up and I am probably in the minority of one or two or five to say that"

If this is the case, what could happen to all those FII inflow that was pouring into the country last year? While the long-term story of India is intact, in the short to medium term, there could be a continued reversal in flow of FII money (as we have been witnessing since April 2004). This could keep stock prices in India depressed. At the end of the day, it has to be remembered that India is just 0.8% of global stock market capitalisation.

Given this backdrop, yes, there are concerns. But we advise investors to plan their equity investment in a staggered manner so that the risk is diversified over a period of time. Do not commit all your funds in one shot.

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