Interest Rate Cycles and How You Can Ride Them

Kripananda Chidambaram, 07 Sep 2011

Interest rates in the economy follow a typical cycle or peaks and troughs. Each cycle may last three to five years, and can totally unexpected at times. Yet, it is somewhat more predictable than the stock markets. This is not a surprise – it simply follows what are called the economic cycles. All industrial and service economies go through these peaks and troughs in what are called economic cycles.

In a typical trough, you will hear noises about inflation, while the economy and job prospects would look encouraging (such as now). Closer to the peak, you will hear concerns about an economic slowdown, while inflation would be benign. If you really want to understand this first-hand, you might want to maintain a simple record of prevailing rates over time, and observe its pattern.

The obvious question is which rate to follow. While the RBI directly touches only the repo and reverse repo rates, and only the deposit / loan rates affect you directly, it is probably the prevailing yield on the Government of India 10-year bond that is the best benchmark. This is the interest rate equivalent to what the Sensex is for the equity markets.

Once you have understood this phenomenon and observed it in practice, there are a set of things you can do to take advantage of this understanding. At the very least, this understanding will help you avoid wrong decision making with your deposits and bonds. If you are a pensioner or otherwise invest primarily in fixed deposits, the interest rate peaks are good times to get into longer fixed deposits (> 5 years) in Nationalised Banks. In a trough on the other hand, you will play for time by keeping money in six-month or one-year deposits.

For people in the higher tax bracket, we usually recommend staying away from the tax-inefficient fixed deposits, and investing in debt mutual funds instead. Now, debt mutual funds come in a vast variety, differing in their type of debt and what is called the duration. During the interest rate peaks, you can opt for longer duration debt funds. This way you will benefit when rates fall. Indeed, in the previous interest rate peak, savvy investors have made annualised returns of 17%-20% while investing purely in Government securities through mutual funds. In troughs, you can stick to floating rate or short duration or even cash funds. This will prevent losses when rates go again on the way up.

In addition to deposit and funds discussed above, there are also PSU bonds traded in the market. These are issued by solid Government backed undertakings like NABARD, Indian Railways or India Infrastructure Financing Corporation Limited (IIFCL). Closer to the peaks, you can scout for these bonds and snap them up at good yields

The relationship of stock markets with interest rates is far trickier, and we will keep it out of scope of the current discussion. Remember, even with rates, you cannot exactly pick the top or the bottom of the cycle, but with a bit of experience and involvement, you can get it right more often than not!

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