While the stock exchanges such as Nasdaq and Intercontinental Exchange reported record amounts in the next quarter, CME Group (NASDAQ: CME) reported a fall in earnings. It ends up that the actions required to encourage the market by the Federal Reserve have worked against CME, largely because a lot of its business is in interest-rate solutions. This was a problem I spoke about pre-earnings. So what really happened?
CME Group is the world’s largest derivatives exchange, surrounding the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange, and the Commodities Exchange. The business makes its money from draining services (which will be ensuring that the buyer gets the cash, the seller gets the securities, then finishing the purchase ) and trade fees. CME also sells its pricing information to customers.
Investors mostly utilize derivatives for hedging purposes, or risk management. Among CME Group’s main products is interest-rate derivatives, which enable all types of consumers from banks to insurance companies to general businesses hedge their interest-rate danger. At the next quarter of 2020, CME Group reported that a 7% fall in earnings, which was mostly driven by a 50% sequential decrease in interest-rate derivatives trading. Average daily volume for interest rate products was 6.9 million. At the first quarter, it had been 13.8 million, and a year ago it had been 11.6 million.
What caused the drop in interest-rate derivatives demand? A collapse in volatility in the bond market. Here is what happened.
Image source: Getty Images.
An unprecedented intervention in the financial markets
In March and April, the Federal Reserve intervened in the markets by pushing the benchmark federal funds rate to a range of 0% to 0.25% and purchasing a massive amount of government debt in order to drive down longer-term interest rates to support the economy. These actions served to drive volatility in the bond market down to eight-year lows.
It is hard to overstate just how big the Fed’s footprint has been in the bond market over the past three months. Before the 2008 crisis, the Fed typically held just under $1 trillion in assets on its balance sheet. In the immediate aftermath of the 2008-2009 financial crisis, the Fed began buying Treasuries and mortgage-backed securities (this was called quantitative easing). By 2014, the Fed held $4. ) 5 trillion in assets. The Fed let some of the assets run off, and by February, it held $4.1 trillion.
It now holds $7 trillion. This increase ($2.9 trillion) is almost as much as the Fed’s holdings increased ($3.5 trillion) from 2009 through 2015. Five years’ worth of purchases over the course of four months. That is astounding.
U.S. Total Assets Held by All Federal Reserve Banks data by YCharts.
The collapse in volatility saps require for interest rate hedging
The net result of the Fed’s buying has been a fall in bond industry volatility. This means the day-to-day movement in prices has been reduced to almost nothing, which is exactly exactly what you would expect to see when a player comes in and overwhelms everyone else in the market. With interest rates close to zero, there is no reason to hedge against a further decline.
The Fed can’t push the fed funds rate below zero, as that would wreak havoc with the internal plumbing of the bond markets. With the Fed also signaling that interest rates will stick at these levels for the next couple of years, investor demand for short-term hedging products dried up. Hedging isn’t free, and many businesses will choose to not pay for it.
That said, the company did raise a great point: The sheer amount of Treasury issuance will increase demand for hedging activity down the road. On the earnings conference call, Sean Tully, global head of financial and OTC products, explained why this lull in volatility might be short-lived.
If you look at the unprecedented deficit this year estimated at 3.7 trillion, now estimated potentially 2 trillion of deficit next year, you’re going to see the highest debt to GDP ratios the U.S. government seen certainly since World War II and possibly ever, you are going to see the highest level of debt in the U.S. ever. … The growth in coupon securities, the growth in debt and deficits once the Federal Reserve reduces its intervention in the market and once the pandemic recedes, the needs for hedging, the needs for our products are being much, much larger I think than ever before in history. So, yes, July is very low volatility. However, the unprecedented debts and deficits and issuance of coupon securities means that the risk that is going to need to be managed on a go-forward basis is going to be much larger than ever.
Obviously, the Fed’s actions will be driven by the COVID-19 crisis. If the disease slowly fades into the background or a vaccine is developed, the Fed will probably try and extricate itself from the markets. That will be the trigger for investors to begin hedging against an increase in rates. If Tully’s predictions of increased future demand for interest rate products plays out, CME Group should return to normal revenue growth. If it doesn’t we will have to wait for the Fed to start thinking about hiking rates. Back in the meantime, the company will continue to develop new products, especially ethical, social, and governance (ESG) indices. This will induce growth as we await a return to normal bond market volatility.
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Brent Nyitray, CFA has no position from any of their stocks mentioned. The Motley Fool owns shares of and recommends CME Group. The Motley Fool has a disclosure policy.
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