Non-linear cointegration between oil and stock prices: the role of interest rates

Abstract

The Zero Lower Bound (ZLB) has been suggested as an explanation as to why oil and stock prices have become highly correlated post 2008. Our paper contributes to the literature on this topic by testing (i) whether there is a long-run relationship between oil prices and stock prices (measured by the MSCI World Index) that is non-linear depending on the interest rate levels and, if this is the case, (ii) whether the co-movement between them is stronger when interest rates are very low. To do so, we apply a cointegrating smooth transition regression approach using a global shadow rate as the transition variable to take into account the possible effects of unconventional monetary policy measures on the oil-stock price linkage. We find evidence in favor of the two hypotheses tested. These results have important implications for portfolio managers and investors, since the benefits of portfolio diversification by investing in oil would be lower in a ZLB context. In addition, from a policymakers’ perspective, the results could be revealing that, in this context, central banks could exert a greater influence than in “normal times” not only on equity prices, but also on global oil prices.