The small open macroeconomy and the yield curve: A state-space representation

•This study extends a state-space representation of the yield curve and the macroeconomy to a small open economy.•The framework treats the U.S. term structure as being exogenous to both the Canadian yield curve and macroeconomy.•The empirical results support very strong links between the yield curves in the two countries.•Canadian yield-curve factors also account for a large portion of the variation in domestic macroeconomic variables.

This study extends a state-space representation of the yield curve and the macroeconomy to a small open economy in order to study the dynamic interaction between the yield curves in Canada and the U.S. The framework treats the U.S. term structure of interest rates as being exogenous to both the Canadian yield curve and macroeconomy. The empirical results support very strong links between the yield curves in the two countries, with the U.S. yield curve accounting for as much as 45 per cent of the variation of the movement in the level and about 30 per cent of the movements in the slope and the curvature of the Canadian yield curve. Canadian yield-curve factors are found to account for about 50 per cent of the variation in output and the monetary policy rate, and about 25 per cent of the variation in inflation, much larger than the yield curve effects found for future developments of the macroeconomies of other countries. A relatively strong bilateral relationship is found to exist between the yield curve and the instrument of monetary policy, supporting recent studies that find the dynamic relationship between the yield curve and the macroeconomy is due to the pivotal role that monetary policy plays in the macroeconomy.