The year 2020 has been difficult for financial stocks. The banks have had to take huge provisions for potential credit losses, while the real estate investment trust (REIT) sector has been beset with struggling tenants. One of the few bright spots in the financial space has been the exchanges, since they generally take very little credit risk. That said, not all exchanges have performed this year. CME Group (NASDAQ:CME) has struggled as the Fed's actions have affected its bottom line. 

Stock chart and list of interest rates

Image source: Getty Images.

Interest rate products account for the majority of CME Group's daily volumes

CME Group is a collection of exchanges that focus primarily on financial derivates -- that is, contracts based on the underlying value of another asset. CME's exchanges include the Chicago Mercantile Exchange, the Chicago Board of Trade, the Commodity Exchange, and the New York Mercantile Exchange. The company's primary asset class is interest rate derivatives, which accounted for 54% of its average daily volume in 2019. Interest rate derivatives include Eurodollar and LIBOR (London Interbank Offered Rate) contracts, and Treasury futures and options. The second-biggest chunk of volume comes from equity index futures (S&P 500, Nasdaq, etc.), and the third is from energy.

Big decline in revenues and earnings driven by a drop in volume

CME Group reported revenues of $1.1 billion for the third quarter, which was a decrease of 9% from the second quarter and 15% from Q3 of 2019. Earnings per share fell to $1.15, a drop of 18% from Q2 and 35% from Q3 last year. Volumes overall fell, with average daily volume falling from 17.6 million contracts in the second quarter to 15.6 million in the third.

The issue has been declining volatility in energy and interest rates, which are core asset classes for CME. Unfortunately for CME, it isn't really something the company can address. The Federal Reserve has exercised unprecedented control over the bond market in order to support the economy, and the side effect has been a collapse in bond-market volatility.

How long will the Fed's intervention last?

The question for CME Group will hinge on how long the Fed's support of the bond market will last. As the government continues to issue new debt, many investors will need to hedge the interest rate risk. This should drive increased demand for hedging products down the road. However, the more knotty issue concerns the simple fact that interest rates are stuck at zero. Companies that would ordinarily have exposure to falling short-term rates no longer have to hedge against that scenario. Short-term rates cannot go negative (although longer-term rates can). This reduces investor demand.

CME Group has been introducing new products, however. One area that has seen robust fund inflows has been environmental, social, and governance (ESG) funds. It has been a phenomenon primarily concentrated among European investors; however, it is picking up momentum in the U.S. and Asia. CME Group recently introduced a water futures contract, which is attracting attention from the same sort of ESG investors. CME has also introduced all sorts of spread products, which allow investors to trade based on the shape of the yield curve. This allows an investor to make more precise hedging decisions, and it reduces transaction costs. 

Choose stock volatility over bond volatility

Investors who want to limit their exposure to credit, yet still want to stay in exchanges, should consider Intercontinental Exchange (NYSE:ICE) or Nasdaq (NASDAQ:NDAQ), which are up for the year, while CME Group is down 25%.

ICE Chart

ICE data by YCharts.

CME Group has an enviable group of exchanges, and volatility will return to the bond market, especially if we see an uptick in inflation. In the meantime, CME will probably struggle compared to the equity exchanges. While the current environment will be temporary, we don't really have any visibility as to when it will change. That is up to the Fed. 

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.