Humped Yield Curve

Also known as the term structure of interest rates, yield curves are typically used depict the relationship between interest rates and the time to maturity of a debt security such as a bond. The shape of the curve provides the analyst-investor with insights into the future expectations for interest rates, as well as a possible increase or decrease in macroeconomic activity. Yield curves are simple line plots showing the term, or maturity, on the x-axis (horizontal axis) and the corresponding rate of interest, or yield, on the y-axis (vertical axis). When plotting a yield curve, the securities should be of similar, if not identical, credit quality.

As the illustration below demonstrates, a humped yield curve at shorter maturities has a positive slope, and then a negative slope as maturities lengthen. This results in what is also referred to as a bell shaped curve. Humped yield curves are rare, and when debt issued by the U.S. Treasury Department results in this type of curve, it's typically interpreted as a signal the economy is slowing down. As is the case with a flattened curve, a humped yield curve cannot be explained by market theories and is a transitional state.

For example, if the returns on five year debt were higher than two and ten year debt, individuals would not choose to invest in the longer-term security, since they are not being compensated for the additional risk they're assuming. This lack of investor interest in longer-term debt would eventually drive their returns higher. In the same way, investors would flock to mid-term debt, eventually driving rates down.

The following illustration demonstrates the shape of a normal versus humped yield curve.