What is a humped yield curve?

Gyrations in the market, negative butterflies or a non-parallel shift in the yield curve can cause a humped curve. But what does a humped yield curve mean? Read on for an in-depth humped yield curve definition.

A humped yield curve is formed when medium-term fixed income securities’ interest rates are higher than the rates of long- and short-term instruments, making it a relatively rare yield curve. It can also form when short-term interest rates are expected to rise and then fall, resulting in bell-shaped curves. 

How does a humped yield curve work? It can provide investors and financial analysts with insight into interest rate expectations, and help gauge highs and lows based on macroeconomic activity. 

Generally, short-term rise or fall in interest rates is influenced by expectations of change by central banks or financial governing bodies. While the long end of the yield curve tends to consider the outlook on inflation, economic growth, demand and supply, and fixed-income securities trade in huge blocks by institutional investors.

Humped yield curve example 

With the humped yield curve explained, let’s consider an example. Say the yield on a seven-year Treasury note is higher than the yield on a one-year Treasury bill and that of a 20-year Treasury bond. Investors would grab the opportunity and invest in the mid-term notes, this would drive the price higher and push rates lower. 

Since the long-term bond has a rate that, according to investors, is not as competitive as the intermediate-term bond, they would avoid long-term bonds, eventually decreasing the value of the 20-year bond and increasing its yield.

Humped vs regular yield curves

The above example calls for clarification on the difference between the meaning of a humped yield curve versus a regularly shaped yield curve. 

In a regularly shaped yield curve, investors receive a higher yield for purchasing longer-term bonds. A humped yield curve does not pay back investors for the risks that exist in holding longer-term debt securities.