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Why Rising Interest Rates Are Helping CME Group | The Motley Fool

Last year was characterized by extreme volatility in the financial markets, especially early on. The COVID-19 pandemic triggered a major sell-off in stocks, and a corresponding rally in bonds.

As a general rule, investing in exchange operators is a smart move during these types of markets, as those businesses bear little credit risk and generate fee income from the increased trading volumes such volatility drives. For CME Group (NASDAQ:CME), the first quarter of 2020 gave way to a steep drop-off in volume for its flagship interest-rate derivatives. Now it looks like things are changing for the better. Is this a good time to buy?

The Fed’s economic supports hindered CME Group

CME Group is the biggest derivatives exchange operator in the world, handling stock index futures, commodity futures, and options, along with currencies and interest-rate products. The group is made up of the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange, and the Commodities Exchange. Last year, average daily volumes were just over 19 million contracts, with 42% of that volume in interest rate futures, 30% in equity indices, 13% in energy products, and the rest in currencies, agricultural commodities, and metals. 

Last year, CME Group faced headwinds due to the Federal Reserve’s energetic actions to keep the U.S. economy afloat. Because the central bank dropped benchmark interest rates down to 0% and actively supported the bond market, demand for interest-rate products declined. In 2020’s first quarter, the daily trading volume in interest rate futures was 13.8 million contracts per day. That number shrank by half in the second quarter, and declined a further 23% to 5.3 million contracts per day in the third.

The reason for those declines was twofold. First, the Fed’s actions decreased volatility in the bond market, and as a general rule, volumes and volatility rise and fall hand in hand. Second, the demand for hedging products fell as interest rates hit the zero bound. If rates are already at 0%, why pay to hedge against the risk of them going negative? While interest rates can indeed go negative in the long-term bond market, they cannot in the short-term markets. 

The economy is gathering momentum

With tens of millions of Americans already vaccinated and many more getting their shots every day, we are seeing an improving economic outlook. First-quarter gross domestic product growth came in at 6.4%, and the Atlanta Fed’s GDPNow model is guiding for 13.2% growth in the second quarter. The CME’s fed funds futures contracts are now handicapping a 12% chance of a 25-basis-point hike (that is, a quarter of a percentage point) in the fed funds rate at the June Federal Open Market Committee meeting. The markets are preparing for rising rates. 

In the first quarter, rising rates propelled average daily volumes upward by 35% from the fourth quarter to 21.8 million contracts per day. While they were still down 19% from a year ago, Q1 2020 was a record quarter for CME Group. In fact, Q1 2021 was the third-most-active quarter the company has seen. Interest-rate futures volumes were up 65% compared to the fourth quarter. Volumes also increased in equities, metals, and energy. 

While interest-rate futures are CME’s bread and butter, rising commodity prices will continue attracting investor interest. Cryptocurrency derivatives and retail-driven products will also help the company grow. Last year, CME introduced 85 new products, which will help it diversify away from its reliance on interest-rate products. 

CME is probably fairly valued

At Thursday’s closing price, CME Group was trading at 30 times expected earnings for the next 12 months. That looks like a rich premium compared to Intercontinental Exchange, which traded around 23 times forward earnings, and Nasdaq, whose multiple was 24.5. CME’s higher multiple could be an indication that the market thinks its earnings will be higher than currently anticipated. Given the way that the economy is growing faster than was forecast, that might be a good bet.

While CME’s stock has underperformed Intercontinental Exchange and Nasdaq over the past year, it has performed similarly to them over the past three months. CME pays a quarterly dividend of $0.90 and paid a $2.50 variable dividend at the end of last year. If you annualize the quarterly dividend and add in the variable dividend, you get a yield of 3%, which is pretty attractive, especially since Intercontinental Exchange and Nasdaq have much lower yields. Overall, CME Group is looking fairly valued at these levels.

 

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.



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