Abstract: This paper analyses the dynamics of the German term structure of interest rates from the perspective of an arbitrage-free multifactor model that comprises both observable macroeconomic and latent driving forces. The framework is similar to that employed in Ang and Piazzesi, JME, 2003. The model is estimated by maximum likelihood based on the Kalman filter using monthly data from 1976 on. We introduce a full set of measurement errors so we do not have to substitute out latent factors for estimation. We conduct an impulse response analysis for the impact of macroeconomic and latent factor shocks on bond yields and risk premia. For the period before EMU, a forecast-error variance decomposition shows that for a long horizon, macroeconomic factors explain more than half of the variance of yields with maturity of up to one year. For longer term bond yields, the proportion explained by output and inflation decreases with time to maturity and forecast horizon. Results for the period after the beginning of EMU are currently very preliminary. They tend to suggest that the explanatory power of macroeconomic variables for yield dynamics is lower than for the period before 1999.