What does the Fed’s interest rate hike mean for CME Group?
Usually a bear market is bad news for a stock market. When the price of an asset class rises, investors seek out that performance, which increases trading volume. The reverse tends to happen when stock prices fall while one class of investors stays away from the markets.
There is however a twist when an asset has natural constraints. Ironically, a bearish bond market could be the best news for CME Group (CME -1.46%), the dominant player in interest rate derivatives. Let me explain.
CME Group: the largest derivatives and commodities trader
CME Group is made up of several exchanges, including the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange and the Commodity Exchange. The Chicago Mercantile Exchange is home to CME Group’s largest products, including interest rate futures and options and equity index futures. CME also trades ethical, social and governance (ESG) products, commodities and alternative investments like private equity, private debt and collectibles.
When the Federal Reserve aggressively lowered interest rates in order to fight the pandemic, it had a negative impact on CME’s interest rate products. The Fed’s moves caused the bond market to rally, and bull markets are generally good for trading. So why didn’t it help the CME group this time around? The reason is that interest rates have reached the zero limit. While long-term rates have turned negative in some parts of the world (German sovereign debt is trading at negative yields), negative short-term rates are not allowed to happen.
When interest rates reach 0%, many transactions will disappear
Interest rate products are used by companies and asset managers to hedge interest rates on assets and liabilities. A borrower may want to use them to convert a variable rate loan into a fixed rate loan. But what happens when interest rates hit 0% and can’t go down? Nobody will pay to cover a risk that cannot happen. And while many people are willing to bet that rates will go up, few takers would bet that rates would go down further.
Average daily volumes recover in interest rates
Now that rates are rising, CME Group is seeing an increase in the average daily volumes of its rates products. In the first quarter of 2022, average daily volumes of interest rate products increased by 21% to 12.5 million contracts. To put that number into perspective, in 2020 average daily volumes were 8 million interest rate contracts.
CME Group holds a quasi-monopoly on its markets. It would be next to impossible for a company to come up with a competing exchange for its interest rate products. The stock trades at 24 times expected earnings per share for 2022. It pays a quarterly dividend plus a variable dividend at the end of the year based on company earnings. Last year, CME paid $3.60 in quarterly dividends plus a special dividend of $3.25. This gave a return of 3.6% based on current prices.
CME took a beating over the past month as the broader market headed lower, but the current environment of rising inflation and rising interest rates is ultimately good news for the market. title.