What Does a Humped Yield Curve Mean for Future Stock Market Returns

As many commentators have pointed out, the yield curve has developed a sort of humped form in recent months. That has led many to speculate about when the yield curve will invert, foreshadowing a recession. If, as the logic goes, the yield curve is about to invert then we all better take cover. After all, the yield curve is a big driver of banks’ incentive to make loans since they borrow money at short-term rates and lend money out at longer-term rates plus a spread. If banks have no incentive to make loans because the marginal profitability of new loans is so poor (i.e. the spread between short-term borrowing and long-term lending is not great enough or even negative), then credit contracts and a downward economic spiral is kicked off.

Unfortunately, the the humped nature of the yield curve itself provides more noise than signal, as forward returns when the yield curve has been humped have been both extremely good and extremely poor. Therefore, must look deeper to gain more clarity as to what the signal is from today’s yield curve shape.

As readers know, the yield curve is typically upward sloping, with longer-term yields higher than shorter-term yields at every point along the curve. The first chart below shows the average yield at each maturity for US Treasury bond market since 1986.

In contrast to that nice upward sloping curve, the current yield curve looks like the next chart. Currently, 1 year yields are higher than 2, 5, and 7 year yields. The current yield curve is neither upward sloping nor downward sloping (aka inverted), it’s humped.