Looking Ahead: Here’s Why Rising Rates Will Help CME Group

The past year was excellent for the companies that operate stock exchanges, as rising stock market volatility, combined with free stock-trading apps like Robinhood, increased trading volumes and the fees that exchanges collected.

Unfortunately, not all exchanges benefited, as evidenced by the relative financial performance of CME Group (NASDAQ:CME) over the past year. The world’s premier derivatives exchange took a partial hit thanks to actions from the Federal Reserve to shore up the broader economy.

But recent changes in the economy suggest the clouds over the stock may be parting. 

The premier derivatives exchange

CME Group is a holding company comprising the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange and the Commodities Exchange, as well as some other exchanges. These exchanges provide the company clearing and fee revenue. CME Group also sells its data and trades stock index futures. 

Abstract picture of a bank

Image source: Getty Images.

COVID-19 hurt fixed income derivatives trading

During 2020, the Federal Reserve cut interest rates to near-zero percent and began buying longer-dated Treasuries and mortgage-backed securities in response to the COVID-19 pandemic. The intent was to lower interest rates to support the economy, which would hopefully mitigate the economic impact from COVID-19-related business closures. 

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CME’s biggest source of income has always been fixed-income derivatives. Derivatives are securities like options and futures, which are typically used to hedge against risk. Last year, interest rate products were 42% of average daily volumes, compared to 54% in 2019. Interest rate daily volume fell 22% to just over 8 million contracts per day.

Why did volumes fall so much? Blame those low interest rates. If a business has interest rate exposure, and it is only hurt if rates fall, why bother spending the money to hedge that risk when rates are already as low as they can go? It is like paying auto insurance on a junked car. 

An economic recovery could be just the ticket

Things have changed since the beginning of the year, however. We have seen a sizable increase in the 10-year Treasury bond yield, which has risen 75 basis points to 1.66%. More importantly, the latest Federal Open Market Committee projection materials showed four voting members forecasting rate hikes in 2022, compared to only one vote at the December 2020 meeting. The committee also increased its forecast for Personal Consumption Expenditure (PCE) inflation from 1.8% to 2.2% for this year.

These increases are largely driven by Federal stimulus measures, which are expected to boost the economy by increasing consumer spending. In addition, unemployment is expected to fall as the population gets vaccinated and people return to normal spending activity. If inflation is rising, and interest rates are increasing, then that volatility will translate into higher trading volumes for CME’s bread-and-butter interest rate products. 

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In 2020, equity index products picked up the slack for falling interest rate product volume. Average daily volumes were more or less flat on a year-over-year basis at 19 million per day. Analysts still see flat revenue and earnings-per-share (EPS) growth for 2021, but there should be upside to those numbers if average daily volumes increase in fixed income derivative trading. 

CME has underperformed its equity exchange peers over the past year, though it has been narrowing the gap over the past several months.

CME Chart

CME data by YCharts

Generally speaking, the exchanges have a massive competitive advantage in that their infrastructure is extremely difficult to replicate. They have a competitive moat, and that is why these stocks generally trade with premium multiples. CME is trading at 31 times expected 2021 earnings per share, but Wall Street is factoring in little to no growth next year. If bond market volatility returns, then those estimates are too low.

The increase in volatility will be dependent on the pace of the recovery. If the stimulus plan doesn’t have the hoped-for effect, then rates will return to lower levels, and the problem of 0% rates stays. However, if the economy picks up speed, CME Group stock could offer an interesting way to play the recovery. 

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.


View more information: https://www.fool.com/investing/2021/03/30/looking-ahead-why-rising-rates-help-cme-group/

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