Stock returns and interest rate differential in high and low interest rate environments

Abstract

AbstractIn this study, we contribute to the literature in three ways. First, we test whether the response of stock returns to interest rate differential contrasts between high and low interest rate environments. Second, we further test whether positive and negative interest rate differentials impact differently on stock returns. For completeness, we examine the role of negative interest rate policy in the nexus by testing whether the response of stock returns to interest rate differential varies between negative and positive low interest rate environments. The third objective becomes necessary as negative interest rate may not necessarily translate into negative interest rate differential and vice versa. Using panel data methods that allow for nonstationarity, mixed order of integration and cross‐sectional heterogeneity in the estimation process, we find contrasting evidence between the two interest rate environments. While the relationship is negative for the low interest rate economies, a positive sign is observed for the high interest rate group. The ‘asymmetry’ effect in the relationship is only evident in the short run and in addition interest rate differential tends to improve stock returns in negative interest rate environment albeit in the short run. We also find contrasting evidence between the positive and negative low interest rates where the nexus remains negative for the positive (low) interest rate group and positive nexus for negative (low) interest rate category.