CME Group (NASDAQ: CME) will announce its second-quarter earnings on July 29. The company's financial exchanges generally perform well in volatile economic times, and the last few months were certainly volatile.
Image source: Getty Images.
Where the world goes to manage risk
CME Group runs a global exchange of derivative products, investments that are often used by investors to hedge against risks elsewhere in their portfolios. It facilitates the trades of futures and options on interest rates, commodities, equity indices, and currencies. It started out as the owner of the Chicago Mercantile Exchange, but in the past couple of decades, it expanded -- first merging with the Chicago Board of Trade, and then acquiring several others, including the New York Mercantile Exchange and the Commodity Exchange.
Exchanges are rather like public utilities: They provide services everyone needs, they operate in largely protected markets, and they provide steady earnings. And for a bonus, they're even more lucrative when other financial-sector companies like banks and real estate investment trusts are vulnerable.
Life at the zero bound
When CME Group delivers that next quarterly report, the number I'll be looking at most closely will be its revenue from interest-rate products, which comes largely from clearing and transaction fees for eurodollar, Treasury, and fed funds derivatives. Interest-rate products accounted for almost half of CME Group's average daily trading volume in the first quarter, and about a third of its clearing and transaction fees. With benchmark interest rates basically stuck on the zero bound, and the Fed projecting they will stay there through 2022, demand for interest-rate hedging products will almost certainly decline.
On the last earnings conference call, the issue of interest rate derivatives activity in an environment of zero percent interest rates came up repeatedly. In response, CEO Terrence Duffy raised a great point about the current environment:
Most importantly, you would have seen at the end of last week, the Congressional Budget Office did announce their estimated $3.7 trillion deficit for the federal government this year. This is obviously completely unprecedented in terms of its size. And if you think about $3.7 trillion deficit, that's $3.7 trillion worth of additional Treasury bills, notes, and bonds that will need to be issued this year, that will need to be risk-managed. If you look at 2019 for example, the net issuance was $984 billion.
If you own an asset that can be hurt by falling interest rates -- say, for example, mortgage servicing rights -- why would you hedge against a drop in rates when the fed funds rate is already sitting in the zero to 0.25% range and the 10-year Treasury rate is a mere 0.60%? Similarly, if you manage a pension fund with a portfolio of bonds that will decline in value on an increase in rates, why would you eat into whatever meager return you're making right now by hedging against a risk that the powerful Fed is actively and openly trying to prevent? However, the massive amount of Treasury issuance this year may offset that drop.
CME Group's stock has not been a strong performer in 2020. Though it has recovered somewhat from the market's spring plunge, it remains down by about 17% through Friday's close, compared to its peer exchange operators like Intercontinental Exchange, which is essentially flat for the year, or Nasdaq, which is up by about 20%. The Intercontinental Exchange and Nasdaq are benefiting from the extreme volatility in the equities markets.
Fears of a decline in interest rate derivative volumes are a big part of the reason for CME's recent underperformance. If it reports sequential growth in interest rate derivative trading volumes and revenues, investors may take another look at the stock.
10 stocks we like better than CME Group
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*
David and Tom just revealed what they believe are the ten best stocks for investors to buy right now... and CME Group wasn't one of them! That's right -- they think these 10 stocks are even better buys.
*Stock Advisor returns as of June 2, 2020
Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends CME Group and Intercontinental Exchange. The Motley Fool recommends Nasdaq. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.