Modelling delayed correlation between interest rates and equity market returns

Abstract

We model the interaction between interest rates and equity markets using wavelet analysis. This approach allows us to study the lead–lag relationships in an intuitive way considering variation across frequencies and over time. Analysis is done progressively on varying scales where the lower scales encompass high-frequency components of the data over a shorter time scale; whereas, higher scales encompass low-frequency components over a longer time scale. We use daily data obtained from Kenya for the period October 2003–2019. The Nairobi Securities Exchange 20 share index returns are used as a proxy for equity returns; whereas, the interbank rates represent interest rates. Three key findings emerge: (1) There is at least 2-month delay in the correlation between interest rates and equity market returns, (2) The correlation is lower in the lower time scales of 4–8 days and higher in higher time scales of 512–1024 days, and (3) Equity returns lead interest rates in Kenya. Unlike common practice of assuming static relationships in asset markets, our findings reiterate the need for modelling dynamic relationships considering delays, time variation and scaling over time horizons.