Yield curves are listed among some of the most critical sources of knowledge, in the world of finance. Its role in banking and the bond markets are especially crucial, as it indicates the market’s perception and willingness on the debt market. One specific type of yield curve is the humped yield curve, with a shape that reports low short and long-term yields, but high intermediate yields. Although this hump-shaped pattern is not as common as the typical curve, it is quite consequential to market participants.
In this article, we delve into this fascinating form of the yield curve and discuss a basic overview of everything there is to know about the humped yield curve. Knowledge of this phenomenon could give you the edge needed to make informed decisions in the market.
What Is a Humped Yield Curve?
A humped yield curve, in the most basic sense, is simply a yield curve, that takes the shape of a hump. A yield curve shows the yields of bonds against their time to maturity, so a curve with a humped shape would appear as follows:
By glancing above at the basic shape of the humped curve, it becomes clear that bonds with intermediate maturities are yielding significantly higher than both short and long-term securities. This gives rise to a unique hump-like shape giving the phenomenon its name.
Identifying this unique curve is useful to market participants and to economists alike. Many argue that the occurrence of this humped curve is the signaling of a potential economic slowdown, with mixed sentiment in the market, and reduced yields in the short term.
Humped Yield Curves Explained
The most direct takeaway from yield curves with a hump is that the market holds mixed expectations about the future, pointing to widescale uncertainty. This is never a positive sign for economic growth and should indicate caution for investors.
The hump shape comes about when market participants expect interest rates to rise in the short and long term, which causes growing demand for bonds with intermediate-term maturities.
Sometimes the humped curve takes shape due to demand and supply factors, when short and long-term bonds are in high supply, relative to their demand, but intermediate bonds have a lower supply.
Overall, there is a combination of factors giving rise to the humped yield phenomenon; some economic, and others specific to the bond market. However, when observed, these curves are always a cause of concern among market participants.
Humped vs. Regular Yield Curves
Unlike the yield curve with the hump shape, the regular curve is upward-sloping, showing higher yields for long-term bonds. They appear as follows:
The regular curve is considered standard market behavior in the yield-maturity dynamic. This is due to investors demanding to be compensated higher, against the risk and inflation exposure they assume for holding it for such a long period.
The hump-shaved curve is considered a deviation from normalcy in the case of yield trends and thus points to market stress due to demand-supply dynamics or due to economic challenges. This is unlike the standard, more common yield curve, which indicates a healthy economy.
Types of Humps
Within the humped yield curve, there is usually one specific type of hump that represents higher yields for intermediate-term bonds, and lower yields for long- and short-term bonds. Analysts and economists recognize this phenomenon by these basic descriptors.
However, the size and prominence of the hump could possibly differ from curve to curve, with some humps being flatter in their vertical length, while others could be a lot taller. The latter is usually considered to be more serious, in terms of economic implications.
The following are some types of yield curves with humps that may form in a bond market:
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Normal hump yield curve
This is a standard hump in a yield curve where the mid-term interest yields are higher than short- and long-term yields. We have spoken at length about these occurrences above.
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Inverted yield curve
In the inverted yield curve, the hump is downward facing, and yields are relatively lower for mid-term bonds than they are for short- and long-term bonds. This would appear as follows:
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Steeping hump yield curve
In this case, the hump in the yield curve would be extraordinarily steep, which emphasizes a much more prominent difference in the demand for intermediate bonds, and short and long-term bonds.
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Flat hump yield curve
The flat hump yield curve is not as serious an alarm bell as the more regular variations of the hump. This only indicates a slight difference in the demand for intermediate-term bonds. However, this could signal the approach of a regular hump yield curve.
Humped yield curve examples
To observe a real-life humped yield curve example, we turn to late 2022, a time when macroeconomic uncertainty was at its peak with skyrocketing inflation. The graph during the time was as follows:
During this period, uncertainty was at its peak across the economy, with the impact felt clearly in the bond industry and banking markets. With no indication of the next interest rate hike of the US Fed, demand for short- and long-term bonds clearly took a dip.
As can be seen in the curve above, there was a marked difference in the yields 10 years and 20-year bonds, as bond investors were demanding a premium for the risk exposure to such a long period of time.
1-year bonds, however, were the most in-demand, during the time, as the market deemed the period as being ideal to hold on to debt securities.
Influencing Factors
There are some core factors that directly influence the shape of yield curves, and understanding them is critical to grasping the nature of yield curves. These factors are as follows:
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Inflation
When inflation is generally high within an economy, the purchasing power of wealth over time diminishes. For this reason, during high inflation periods, investors demand higher compensation on long-term bonds.
Similarly, in cases when inflation is low, even low yields on bonds are acceptable to the market at large, influencing the shape of the curve.
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Economic Growth
During times of high economic growth, industries, and the wider economy are in expansion mode, making it a great time to invest. Yield curves would be upward-sloping, as investors seek to capture the growth through bond investments.
When economic growth is low, however, and a recession may be looming, bond market players are less greedy in their ambitions, and are willing to tolerate lower yields over the long term.
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Interest Rates
When a state’s federal reserve or central bank adjusts short-term interest rates to address inflation, there is a direct bearing on the entire yield curve. The starting point of the curve is shifted, and the curve flattens.
The flattening happens because short and long-term interest rates become more aligned. Conversely, when short-term rates are dropped, the curve steepens, and its upward slope becomes more prominent.
Importance of the Humped Yield Curve
The yield curve is a fundamental economic tool that rests on the assumption that the bond market is a reliable source of economic knowledge. The same is applicable to the humped yield curve, with the rich insight the phenomenon delivers.
The humped curve is a great forward-looking signal, as it highlights that the market expects inflation and interest rates to experience a temporary boost in the intermediate timespan. This makes it a valuable source of information policymakers can use to implement change.
Although such humped curves are rare occurrences, their observation can act as an alarm bell not just for economists, but for investors and traders too, as it signals economic slowdown, and subsequently the limiting of capital gains in the bond, stock, and derivative markets.
Conclusion
The humped yield curve is a rare but highly significant market phenomenon that can help predict macroeconomic conditions in the near and long-term future. As a result, they help prepare the relevant economic actors to align their decision-making to the oncoming realities.
In yield curves, there are a number of humped variations, each that arises out of distinct conditions, and have different implications. Unlike regular yield curves, those with the humped shape represent an abnormal condition in the market, which could act as a call to action.
The yield curve is influenced by several factors, which are both economic, and market-related. The most significant of these are inflation levels, economic growth, and interest rates.
In its essence, a hump-shaped yield curve represents the intricate and dynamic relationship between the financial and economic realms, and how the product of these complex areas can aid decision-making at a broad level.
FAQs
How can the Fed fix a humped yield curve?
The Fed can fix a humped yield curve by adjusting the short-term interest rates until the shape of the curve takes on a more normal form. It would raise the short-term bond rates to flatten the curve and remove its hump.
What is the difference between a normal, abnormal, and humped yield curve?
A normal yield curve is upward sloping where long-term bonds yield higher than short-term bonds, whereas abnormal yields are the opposite and downward sloping. In a hump-shaped yield curve, both short and long-term bonds have low yields, and intermediate have high yields.
What is a humped graph yield curve?
In a humped graph yield curve, a specific trajectory is observed where interest rates remain low for short-term bonds, rise for mid-term bonds, and then drop back down for long-term bonds.
