Worthwhile Canadian Initiative thinks I'm wrong when I write:
Worthwhile Canadian Initiative: Yes, we should be worrying about the US yield curve : This inversion of the yield curve, however, is generated not by domestic investors' thinking that a recession is on the way, but by foreign central banks' desires to keep buying lots of dollar-denominated bonds in order to keep their currencies from appreciating. Thus while an inverted yield curve is usually a sign that a bunch of people are trading bonds on their belief that a recession is likely, that is not what is going on in this case.
It writes that I have a
plausible story, but I don't think it's correct. If bond markets thought that there was little chance of a US recession in the near future, then the term structure of Canadian interest rates wouldn't be following US patterns. No-one's going to make any particular effort to prevent their currency from appreciating against the CAD, and since Canadian macroeconomic fundamentals are so strong, the only major thing that we have to worry about is the possibility of a US recession. Here's a graph of the Canadian and US yield curves from December 2005 and December 2004.... It looks as though bond traders in both markets are expecting the same thing: a slowdown (or worse) in the US - and therefore Canada - for 2007. And it also seems as though they're expecting the CAD to appreciate even further against the USD.