The role of the yield curves

Let’s use the forward rate ratio (FRR) between 2 and 10 years as a measure of the yield curve’s steepness. This measure is the forward rate between 2 and 10 years, divided by the 10-year rate itself. The more the FRR exceeds 1.00, the steeper the yield curve. A FRR less than 1.00 indicates inversion. Prior to the Federal Reserve’s embarkation on aggressive rate easing in spring 2001, the U.S. and Canadian FRRs were nearly identical. Once the Federal Reserve eased aggressively and the Bank of Canada did not match, the CAD began to strengthen.

The major monetary policy divergence occurred in the aftermath of Sept. 11 and extended into the Spring of 2004, a period highlighted with a box . The CAD continued to firm both throughout this period and well into 2005, despite the fact that U.S. monetary policy became tighter than its Canadian counterpart in early 2005.

A second way to illustrate this phenomenon is the absolute spread between CAD and USD LIBOR as a percentage of the USD LIBOR. Short term CAD swap rates stood well over USD rates by mid-2003, a move certainly supportive of a stronger CAD. By mid-2005, the yield advantage switched to the USD, which should have weakened the CAD if it was the only factor. The USD advantage started to erode by late 2005, a period in which the CAD moved to a multi-year high against the USD. The comparative USD and CAD yield curves have remarkably parallel shapes as of late-December 2005. The CAD curve is a little steeper at the money-market maturities (those less than one year), while the USD curve is noticeably flatter at the note maturities (those between one and 10 years).