Usually, a bear market is bad news for an exchange. When an asset class is rising in price, investors chase that performance, which increases trading volume. The reverse tends to happen when stock prices fall as a class of investors stays away from the markets.
There is a twist, however, when an asset has some natural constraints. Ironically, a bond bear market might be the best news for CME Group (CME -1.93%), the dominant player in interest rate derivatives. Let me explain.
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CME Group: The biggest trader of derivatives and commodities
CME Group is comprised of several exchanges, including the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange, and the Commodity Exchange. The Chicago Mercantile Exchange is home to CME Group's biggest products, including interest rate futures and options and stock index futures. CME also trades ethical, social, and governance (ESG) products, commodities, and alternative investments like private equity, private debt, and collectibles.
When the Federal Reserve pushed interest rates down aggressively in order to combat the pandemic, it negatively affected CME's interest rate products. The moves by the Fed caused the bond market to rally, and as a general rule, bull markets are good for exchanges. So why didn't it help CME group this time around? The reason is that interest rates were up against the zero limit. While long-term rates have gone negative in parts of the world (German sovereign debt traded with negative yields), negative short-term rates aren't permitted to happen.
When interest rates go to 0%, a lot of trading will disappear
Interest rate products are used by corporations and asset managers to hedge the interest rates on assets and liabilities. A borrower might want to use them to turn a floating-rate loan into a fixed-rate loan. But what happens when interest rates go to 0% and cannot go lower? Nobody is going to pay money to hedge a risk that cannot happen. And while there might be many people who are willing to bet that rates are going to go up, there were few takers who would bet that rates would fall further.
Average daily volumes are picking up in interest rates
Now that rates are heading back up, CME Group is seeing an uptick in average daily volumes in its interest rate products. In the first quarter of 2022, average daily volumes of interest rate products rose 21% to 12.5 million contracts. To put that number into perspective, during 2020, average daily volumes were 8 million contracts in the interest rate space.
CME Group has a near-monopoly in its markets. It would be almost impossible for a company to come in and create a competing exchange for its interest rate products. The stock is trading at 24 times expected 2022 earnings per share. It pays a quarterly dividend plus a variable dividend at the end of the year based on the company's earnings. Last year, CME paid $3.60 in quarterly dividends plus a $3.25 special dividend. That worked out to a 3.6% yield based on current prices.
CME has been beaten up over the past month as the entire market has headed lower, but the current environment of rising inflation and rising interest rates is ultimately good news for the stock.
