Looking for another way to play rising interest rates besides
buying banks? How about the world's largest futures exchange which
handles over $3 trillion worth of interest rate derivatives
contracts every day.
CME Group (CME) created the world's largest market place for yield
curve hedging by institutions and corporations when it bought the
Chicago Board of Trade a few years ago. This brought 30-year
Treasury bond and 10-year Treasury note futures under the same roof
as CME's flagship interest rate product, Eurodollar futures.
What's a Eurodollar?
Eurodollar futures are a vehicle designed to allow banks,
companies, and other financial entities with lending or borrowing
risk exposure to hedge short-term rates on US dollars on deposit
overseas. London is the home of the cash market for trading dollars
in foreign banks and thus Eurodollar interest rates are closely
related to the London Interbank Offered Rate (LIBOR).
At CME, quarterly futures contracts are available going out ten
years so that institutions can create complex hedging programs that
cover many types of interest rate risk, from corporate loans that
may not commence for many quarters to large bank mortgage
portfolios with sophisticated duration exposures.
Because each Eurodollar contract represents $1 million in exposure,
when CME trades 2.35 million futures and over 600,000 options on
futures in this product in a given day (2Q average daily volumes),
this combined with Treasury futures volume creates the $3 trillion
in notional value that represents the exchange's importance to the
world's banking and derivatives markets.
And when the yield curve starts to move, these trading volumes ramp
up as volatility and uncertainty increase. For comparison, 2Q2012
average daily volumes were 1.7 million Eurodollar contracts and 1.2
million 10-year note contracts traded (vs. 1.6 million this year in
Turnaround in Progress
What has this volume surge done for CME's earnings outlook? Take a
look at the Zacks custom Price & Consensus chart below which
plots annual estimate changes against price.
Clearly, many investors were scooping up CME shares this year
before the estimates turned enough to make it a Zacks #1 Rank
(Strong Buy) on July 20. But the Zacks Rank was effective in
keeping you out of the stock as it wallowed between $50 and $60 for
nearly a year.
In mid-2012, CME became a Zacks #5 Rank (Strong Sell) as earnings
estimates began a downward trajectory. It remained a #5 or #4 Rank
(Sell) throughout the rest of the year and into February 2013.
Then in March, it stabilized at a #3 Rank (Hold) around $62. And on
July 2, it became a Zacks #2 Rank (Buy) for the first time in over
CME reported second-quarter results last week on August 1 and we
are still waiting to see if analysts are going to adjust their
earnings estimates up or down after the company beat expectations
but guided Q3 lower. This will be the key data that determines
whether the stock remains a #1 Rank.
From Bellies to BTUs
I've followed the business of CME for nearly two decades, ever
since I first walked onto its trading floors in 1994. I've watched
it transform from an open-outcry auction venue for price discovery
in the raucous pits to a Pentagon-caliber electronic fortress for
global risk management handling billions of dollars worth of
hedging and speculation every second amidst all asset classes.
CME Group, the new name for the company after the CBOT acquisition,
has a rich history of commodities trading, dating back to the
invention of forward grain contracts in the 1840s in Chicago. When
I was on the trading floor, I had the opportunity to work in the
infamous Pork Belly pit.
The century of success with agricultural products and the flawless
fiduciary responsibility of the Clearing House led to innovations
with financial products like currency futures and stock indexes
such as the popular E-mini S&P contract. And the acquisition of
the New York Mercantile Exchange gave CME Group ownership of the
A Financial-Infrastructure Powerhouse
What I realized years ago is that CME, "where the world comes to
manage risk" in all these asset classes, is as much a technology
company as a financial one. All exchanges, including CBOE or NYX,
have to be masters of technology, just like Amazon, UPS, or Visa.
CME also has the potential to benefit more from OTC interest rate
and commodity swap transactions being moved to an exchange clearing
house model. With over $600 trillion in OTC derivatives out there,
there is big opportunity for CME right in their own "wheel house."
Combine their technology mastery with Clearing House integrity,
product innovation, and international growth opportunities and you
have a stable and vital franchise -- a utility of finance, you
could say -- that can grow transaction volume even without
It just so happens that right now, CME could be riding the wave of
higher trade volumes from higher yield curve shifts for many
quarters to come.
Kevin Cook is a Senior Stock Strategist with
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