Estimating the Term Structure with Macro Dynamics in a Small Open Economy∗

We study the joint dynamics of bond yields and macroeconomic variables in a New-Keynesian small open economy model complemented with a no-arbitrage term structure model. With Canadian data, we are able to study the impact of domestic and foreign (US) shocks on the yield curve. The unconditional variance decomposition of the yield level show that the movement of expected short rates is mainly driven by US macroeconomic shocks. The majority of the variation of the yield risk premium are also driven by US macroeconomic shocks. However, the Canadian monetary policy shocks can explain a small proportion of the variation of the short to medium yield risk premium. In addition, the Canadian monetary policy shocks and US aggregate demand shocks explain a majority of the variation of the expected excess holding period returns of short to medium bonds. The expected excess holding period returns of long term bonds are mainly driven by US aggregate supply shocks.