The economic story of the past few months has been inflation, which is rising at its highest level in over a decade. Exacerbated by pandemic-driven supply chain bottlenecks, inflation has driven up the price of everything from real estate to lumber. To respond to inflation, the Federal Reserve is taking measures that will push up interest rates.
While rising rates are normally a negative for companies in general since they increase borrowing costs and generally depress the economy, rising rates are good news for derivatives giant, CME Group (CME -1.60%).
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The largest derivatives exchange in the United States
CME Group is the United States' largest exchange for financial derivatives, which are instruments whose value is tied to some other financial product. One of CME's biggest contracts is interest rate futures. These are products such as futures and options on Treasuries, and short-term interest rate contracts linked to the Secured Overnight Financing Rate (SOFR), among many other products.
These interest rate products are typically used by companies to lock in financing costs or the interest they may earn on funds they have lent out. As a general rule, when companies hedge a risk, they are trying to ensure that they don't lose money if the market moves against them. Ever since the early days of the pandemic, short-term interest rates have been stuck more or less at zero.
There is no point in protecting against negative interest rates
Because interest rates aren't supposed to go below zero, this creates a problem for an exchange like CME Group. Ordinarily, investors who want to protect against falling rates will transact with someone who wants to protect against rising rates. With interest rates stuck at zero, nobody is going to pay money to ensure against rates falling below zero. Why insure against something that cannot happen?
As a result of 0% interest rates, CME Group saw big declines in average daily volumes for its interest rate products. In 2020, average daily volumes for interest rate products fell 22%. Average daily volumes are rebounding as investors anticipate higher interest rates in the future. The company just reported that fourth-quarter average daily volumes increased 26%, which was driven by a 56% increase in average daily volumes for its interest rate products.
Commodities and cryptocurrencies provide upside
CME Group also benefits from rising investor interest in commodity prices; commodities were a favorite asset class of investors during the high-inflation 1970s. Energy product volumes were up 16% in the fourth quarter as well, and cryptocurrency products are picking up steam. If inflation remains strong and equities begin to wither under higher interest rates, fast money will probably head into the asset class, which would boost volumes further.
The era of 0% interest rates appears to be over. The Federal Reserve's dot plot predicts three rate hikes this year. The Fed Funds futures are torn between three and four rate hikes this year. CME Group is expected to see earnings per share grow 10% next year, and it's trading at 30 times expected 2022 earnings per share. This may seem expensive, but CME has an extremely hard-to-duplicate competitive moat, which warrants a premium multiple. Interest rate trading will drive earnings next year. If commodities also see increased investor interest, there could be upside to CME's earnings and dividend.
