The economic history of the past few months has been inflation, which hit its highest level in over a decade. Exacerbated by supply chain bottlenecks caused by the pandemic, inflation has pushed up the price of everything from real estate to timber. To respond to inflation, the Federal Reserve is taking action that will drive up interest rates.
While the rate hike is normally negative for businesses in general because it increases borrowing costs and generally depresses the economy, the rate hike is good news for the derivatives giant, CME Group (NASDAQ: CME).
The largest derivatives exchange in the United States
CME Group is the largest exchange in the United States for financial derivatives, which are instruments whose value is linked to another financial product. One of the biggest contracts in CME is the interest rate futures contract. These are products such as Treasury bill futures and options, and short-term interest rate contracts tied to the Secure Overnight Finance Rate (SOFR), among many other products.
These interest rate products are typically used by businesses to lock in financing costs or interest they can earn on funds they have loaned. Typically, when companies are hedging a risk, they try to make sure that they don’t lose money if the market moves against them. Since the early days of the pandemic, short-term interest rates have been more or less stuck at zero.
There is no point in protecting yourself against negative interest rates
Because interest rates aren’t supposed to go below zero, this creates a problem for an exchange like CME Group. Normally, investors who want to protect against falling rates deal with someone who wants to protect against rising rates. With interest rates stuck at zero, no one will pay any money to make sure the rates fall below zero. Why insure against something that cannot happen?
Due to the 0% interest rates, the CME Group experienced sharp declines in average daily volumes for its interest rate products. In 2020, the average daily volumes of interest rate products fell 22%. Average daily volumes rebound as investors anticipate higher interest rates going forward. The company just announced that average daily volumes in the fourth quarter increased 26%, driven by a 56% increase in average daily volumes for its interest rate products.
Commodities and cryptocurrencies offer an advantage
The CME Group also benefits from the growing interest of investors in commodity prices; commodities were a preferred asset class for investors during the high inflation 1970s. Energy product volumes also rose 16% in the fourth quarter, and cryptocurrency products are gaining momentum. If inflation remains strong and stocks start to wither under higher interest rates, the quick money is likely to flow into the asset class, which would further increase volumes.
The era of 0% interest rates seems to be over. The Federal Reserve dot plot expects three rate hikes this year. the Federal funds futures are torn between three and four rate hikes this year. The CME Group is expected to see its earnings per share increase by 10% next year, and it is trading at 30 times the expected earnings per share in 2022. It may sound costly, but CME has an extremely difficult competitive gap to duplicate. which justifies a premium multiple. Interest rate swaps will boost profits next year. If commodities also attract increased investor interest, CME’s earnings and dividend could be on the rise.
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