One of the biggest stories for investors in the past few weeks has been the inverted yield curve. As Investopedia explains,

“An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.

A partial inversion occurs when only some of the short-term Treasuries (five or 10 years) have higher yields than 30-year Treasuries. An inverted yield curve is sometimes referred to as a negative yield curve.

Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle.

A recent example is when the U.S. Treasury yield curve inverted in late 2005, 2006, and again in 2007 before U.S. equity markets collapsed. The curve also inverted in late 2018. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are demanded, sending the yields down.”

The most recent inversion is shown in the chart below.

Source: StockCharts.com

Trading based on the Inversion

This event creates potential risks for investors. But, as in all investment environments, there are also possible rewards. Barron’s recently noted,

“There was a seismic shift in investor psychology when the yield curve inverted [recently]. A trifecta of events drove investors to safety in long-term Treasuries, causing yields to fall lower than that of shorter-dated Treasuries—what is called a yield-curve inversion.

This recession signal was flashing red, but there was—and still is—green to be made.

More than a handful of long-duration bond exchange-traded funds, such as the iShares 20+ Year Treasury Bond ETF (NYSE: TLT) and the Vanguard Long-Term Bond ETF (BLV), hit new highs [after the inversion].” A chart of TLT is shown below.

Barron’s continued, “When the yield curve inverted, the longer the duration, the greater the boost, and the more likely that the ETFs were going to make new highs, says Will Geisdorf, the ETF strategist at Ned Davis Research.

To bet on a flatter yield curve, the classic strategy for bond investors is to have a “barbell”—a fixed-income portfolio mostly made up of positions at the short and long end.

That means cash or money market funds, which yield more than 2% with very low risk, on one end, and longer-dated Treasury ETFs, such as Vanguard Extended Duration Treasuries (NYSE: EDV) and Pimco 25+ Year Zero Coupon U.S. (NYSE: ZROZ), on the other.” The chart of EDV is shown below.

This strategy can deliver significant gains.

“With perfect hindsight, this barbell positioning would have been the bet to make when 10-year Treasury yields hit a peak at 3.23% in early October, as prices rose on longer-dated bonds.

The Vanguard Extended Duration Treasuries ETF, which invests in bonds dated 20 years or longer, returned 16% from Oct. 5 through [late March]. The iShares Short Maturity Bond ETF (NEAR) returned 1.3% over the same period.

The ProShares UltraShort 20+ Year Treasury ETF (TBT), which bets on long-term bond prices falling, thereby increasing yields, fell 19%.”

However, the next few months could be more difficult, “The barbell might be close to played out. The yield curve may begin to steepen if the yield on the 10-year Treasury note bottoms where it has been recently, at 2.37%, as prices grew too rich for investors.

That shows up in the performance of two exchange-traded notes that aim to execute specialized, and inverse, strategies in one product—the iPath U.S. Treasury Flattener ETN (NYSE: FLAT) and the iPath U.S. Treasury Steepener ETN (NYSE: STPP).

Betting on what the pros call a steepener trade could be useful in active funds, says Anne Mathias, who manages more than $720 billion in active fund assets in Vanguard’s fixed-income group.

Mathias does not see a recession on the horizon, but expects the economic environment to improve in the back half of the year as trade tensions ease.

“There is a maxim that the Federal Reserve causes recession by hiking interest rates too quickly, but they are communicating a policy approach that diverges from historical tightening cycles,” she says.

The market has begun to digest the Fed’s new approach, which the central bank has had difficulty communicating, she adds. “The Fed has told us they want to encourage inflation to a point where it rises above the 2% average. It’s too early to declare inflation dead and gone,” Mathias says.

With a “bullet” strategy, in which investors own more intermediate-term bonds and eschew the short and long ends, can work if the yield curve steepens; prices for intermediate-term bonds rose [after the inversion].

That could become a more attractive strategy if short-term rates fall, but that would require the Fed to actually cut rates—on which the federal-funds futures market places a 70% probability by year end, according to the CME FedWatch site.

For now, going agnostic with a market-neutral ETF like the iShares Core U.S. Aggregate Bond (NYSE: AGG) could be the better bet.”

In summary, as there almost always is, there is a lack of consensus among investment experts. 

Where does that leave individual investors? While there’s no consensus and certainly “no guaranteed to be correct” answer, now could be a time when diversification can help reduce risk. Betting on just one strategy could result in large losses. Diversification can deliver more balanced results.

It could also be beneficial to decrease risks. Investors who have all of their assets in stocks could consider this to be an ideal time to take some profits or add fixed income assets to their portfolio.

Increasing cash could be the best strategy in an uncertain market, one that reduces risks even if it reduces the potential gains of a bull market.

The yield curve inverted and that led to a scramble among analysts to forecast the implications. The most obvious implication is that the yield curve typically inverts prior to a recession. That seems to be well known and is now widely covered in the financial media.

The relationship between an inverted yield curve and recessions can be seen in the chart below.

Source: Federal Reserve

The chart shows the difference in interest rates between the 10 year Treasury note and the 3 month Treasury bill. This is one way of looking at the yield curve which measures the differences between interest rates of varying lengths.

When the yield curve is normal, the value of this interest rate spread is above zero which indicates that the rate on ten year Treasuries exceeds the rate on three month Treasuries. This is what we’d expect since longer term loans generally carry higher interest rates.

The dark horizontal line in the chart above marks zero. Moves below zero have been followed by recessions which are shown as the vertical grey bars on the chart.

More Than a Recession Indicator

A research note from Alan Ruskin, global macro strategist at Deutsche Bank, according to MarketWatch.com notes the relationship between the yield curve and the volatility of the stock market.

Riskin said,

“Fear not, ‘the vol cavalry’ are finally coming. Who says so? The yield curve,” he said, in a [recent] note. It ends up that the yield curve is very strongly correlated with all the usual measures of stress, including the VIX, the Cboe Volatility Index, an options-based measure that illustrates expected S&P 500 volatility over the coming 30-day period (see chart below).

Source: MarketWatch.com

It also correlates with other volatility measures, like Deutsche Bank’s own gauge of realized forex volatility, and the MOVE index, which measures bond-market volatility. Ruskin said it also tracks well with measures of financial conditions like the Corporate BAA-U.S. Treasury 10-year credit spread.

“In all cases, the message is fairly simple — the ‘vol cavalry’ are indeed coming, but they have had a long ride in, for the yield curve typically leads the…vol measures by close to three years,” he said.

 Indeed, the typical lag between the 10-year/2-year yield curve and the VIX is 33 months, while bond and currency volatility lag by 36 and 40 months, respectively.

For those that view volatility as synonymous with trading opportunities, those long lags aren’t as worrisome as they may sound, Ruskin said. He noted that the curve has been trending flatter since 2014.

That means “we should already be ‘over the hump’ whereby the curve is increasingly associated with a pickup in vol.”

The VIX has been near a level of 15 recently, less than half the level reached in late December when the VIX closed as high as 36.07.

The current readings are below the VIX’s long term average which is over 19.

Sound Reasoning For the Relationship

MarketWatch asked, “So why does a flatter curve portend volatility? It’s because flattening tends to lead growth slowdowns, which are themselves associated with an increase in volatility.

“In this way, rather than attributing direct causation, it could be that the yield curve is a good leading indicator of the growth cycle, and it is growth that may be more directly causing/influencing volatility,” Ruskin said.

“In this instance, the yield curve predicts a slowdown, and the slowdown breaks the normal recovery phase, and that this break from stability creates the market stress.”

Of course, it’s possible that the currency cycle is different. Interest rates across major economies remain extremely low, which means that adjustments in policy rates will be modest, limiting the potential for big moves in rate spreads, which are the “bread and butter” of currency volatility.

Other policy measures, including the Bank of Japan’s yield-curve control program are a “direct attack” on bond volatility, he said.

At the same time, constraints on central banks’ rate policy and the limited degree of freedom that gives policy makers scope to respond to economic events can also be a source of volatility, he said, which should be encouraging for riskier assets like equities and emerging market assets and currencies.”

Trading the VIX

While VIX itself is not directly tradable, iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) does show a high correlation to the index and could be used to trade this idea.

VXX is an Exchange Traded Note (ETN). An ETN is similar to an ETF. It can be bought and sold just like a stock and has low trading costs. The difference between the two is that an ETF owns stocks while an ETN owns derivatives, adding another level of risk to the investment.

A derivative is a trading instrument that is based on something else. It will always have an expiration date. On that date, the contract will spell out settlement terms. An option on a stock is an example of a derivative. At expiration, the settlement calls for delivery of stock if the option is above or below a certain price. Otherwise, the contract is worthless.

Underlying holdings consist of futures contracts on the VIX. These are exchange trade futures and are therefore as free from default risk as possible for a derivative. That makes VXX an ideal choice for conservative investors seeking a volatility trade.

VXX itself is volatile.

If there is an increase in volatility the ETN should be expected to move higher. That could deliver gains to investors. Because of the risk, investors might want to consider using options on VXX.

A call option on VXX could move higher if the price of the ETN rallies. However, the risk is limited to whatever the investor pays to open the trade. Call options are generally available for less than 10% of the price of the underlying security and will lead to risks of just a few hundred dollars, or less, to potentially benefit from the price move of 100 shares.

While calls might not be right for all investors, they could be the most risk averse trade for investors seeking to gain exposure to volatility as an asset.

Some investors love turnarounds. That makes recent price moves in Chipotle Mexican Grill (NYSE: CMG) potentially appealing.

It’s been almost four years but many investors, and customers remember the news. Customers fell ill and the stock sold off sharply after a food poisoning outbreak in late 2015. Since then the company has taken numerous steps to restore the brand’s reputation.

The latest quarterly results indicate the efforts could be paying off as revenue is returning to the pre-crisis levels.

Source: Standard & Poor’s

Analysts Express Caution

There was quite a bit of good news for shareholders in recent weeks. The stock price crossed above $700 for the first time since 2015. The company reported 6.1% same-restaurant sales in the quarter, with higher prices accounting for 4.1% and transaction growth accounting for 2%.

Stores have made digital ordering easier and begun designing restaurants to make it easier to pick up orders without waiting in line. For drivers, there is even a “Chipotlane,” a new kind of drive-through lane that lets people order ahead.

Chipotle expects its same-restaurant sales to rise in the mid-single digits this year.

Analysts are raising their estimates for the company, according to Barron’s. But, the news service warns. “the latest estimates show the stock trades at 39 times expected 2020 earnings, a remarkable multiple even for a company on the comeback trail.”

Reasons for caution include the fact that “the company has made it more complicated to judge its earnings, because for the past few quarters, it has given investors two different numbers—one that adheres to generally accepted accounting principles, or GAAP, and one that doesn’t.

And the sizable difference between the two is hard not to notice.

The GAAP number wasn’t quite so earthshaking—annual profits rose 2.3% to $6.31 from $6.17. But the company now gives another non-GAAP number that strips out restaurant closing costs and adjusts for items the company considers “corporate restructuring,” including things like accelerated depreciation for some restaurants expected to close.

Using the non-GAAP figures, Chipotle earned $9.06 per share in 2018, a 33% increase from 2017. That kind of growth could presumably justify a multiple of 39 times.

It isn’t unusual for companies to use non-GAAP figures. But Chipotle didn’t release non-GAAP numbers in the same period a year ago, even though it closed or relocated 25 stores in 2017 (versus 54 last year).

In an email to Barron’s, Chipotle CFO Jack Hartung wrote that the company is giving investors more information by reporting both numbers.

“To be clear and transparent, we have reported results both with and without these non-recurring charges, to provide our investors with a clear picture of our underlying results,” he wrote.

The charges “relate to transformation of the company moving the offices and closing underperforming restaurants.”

Wall Street tends to base its expectations off the non-GAAP numbers, though some analysts hope Chipotle’s use of those figures is a temporary change.

“We’re giving them a pass because of the headquarter move to Orange County and the strategic closure of a handful of units,” wrote Wedbush analyst Nick Setyan in an email to Barron’s.

“These one-time expenses should be done by the second quarter of 2019. If they are not done, then it could become a greater concern.”

The non-GAAP numbers aren’t the only reason to be skeptical over Chipotle’s valuation. The company’s restaurant-level margin was up compared with last year, but it fell on a quarter-over-quarter basis.

And some sales gains in the fourth quarter got an extra boost from unique events whose benefits may not last. At the end of the year and the start of 2019, the company offered free delivery, advertising the service on college football bowl game telecasts.

The promotion clearly generated a big response, but it isn’t clear that it will continue to pull in the same number of customers when they have to pay for delivery.

Analysts estimated that the company’s same-restaurant sales jumped about 10% in December, versus about 4% in October and November. Given that the company expects mid-single digit growth next year, it is unlikely it can keep the same momentum for 2019.”

Other Analysts Are Bullish

In a different article, Barron’s offered the bullish case.

“Piper Jaffray analyst Nicole Miller Regan reiterated an Overweight rating on the shares, along with a $725 price target that is the second highest on Wall Street. The latest run-up for the stock started in early February 2018 and has been pulled ahead by an in-process turnaround led by new management.

As upbeat as things might seem today, Wall Street analysts appear less bullish then they were at previous highs, Regan suggested, and if they come around, further share appreciation might be in the offing.

To illustrate: Today, Chipotle stock trades at about 38 times estimated 2021 EPS of $18.69. The Street’s average price target, around $568, is below current prices. Less than 30% of Wall Street ratings are at Buy or equivalents.

At the end of August 2015, when the stock hit an all-time high, the stock was trading at 29 times estimated 2017 EPS of $24.52. But the Street’s average price target was above $700, and the percentage of ratings that were at Buy was closer to half.

Regan praises the management team, which she called “highly collaborative and aligned” in her note. Fourth-quarter earnings came in better-than-expected.

“Operational excellence lays the groundwork for improving guest satisfaction, increasing intent to return and enhancing loyalty,” she wrote.

”Store level efforts are focused on retention, throughput and consistency. Increasing access and awareness is the strategy to identify new guest and target current customers.”

“Despite high expectations, sell-side sentiment and fundamentals are not aligned,” wrote Regan. “We suppose this could always lead to an upgrade cycle as the turnaround continues to unfold, which could benefit the stock down the road.”

The case for the bulls is a strong one as is the case for the bears. It could be best to use a strategy that limits risk, such as one that relies on options and can benefit from whichever scenario you believe is most likely.