Fed Poised to Deliver a Gift to CME Group, Automated Traders

All Eyes on Yellen as Markets Await Rate Decision
  • Shares of CME are locked in closer relationship to Treasuries
  • Automated traders love the volatility that Fed may inspire

The Federal Reserve’s decision tomorrow on whether to boost interest rates for the first time since 2006 is poised to reinvigorate exchange operator CME Group Inc. and line the pockets of automated traders like Virtu Financial Inc.

CME bulked up its rates business eight years ago by spending about $10 billion to buy rival Chicago Board of Trade. That was just before the global financial crisis forced the Fed to cut its benchmark to almost zero in 2008 and keep it there ever since, removing a reason to use CME’s futures and options contracts to speculate on rates and hedge risk. CME’s rates volume has yet to surpass its 2007 record.

Though all of Wall Street is captivated by what the Fed will do, few companies are seeing their fortunes more linked to benchmark rates than CME. Its stock price is locked in its tightest correlation with fluctuations in U.S. Treasury yields since the 2008 crisis. One-fourth of CME’s third-quarter revenue came from rates products, its biggest business.

“They are obviously the ones who would benefit the most from the higher rates,” Paul Gulberg, an analyst at Portales Partners in New York, said of CME. “They pretty much dominate the U.S. interest rates business.”

The 120-day correlation between moves in CME's stock and 2-year Treasury yields has tightened to levels last seen in 2008.
The 120-day correlation between moves in CME's stock and 2-year Treasury yields has tightened to levels last seen in 2008.

Josh Brown, the chief executive officer of Ritholtz Wealth Management, recently went as far as calling CME “the perfect equity proxy for rising rates,” citing his own correlation study.

When CME went big on rates in 2007, there was an immediate benefit. For 2007, it reported average daily volume for rates products of 7.1 million contracts, a surge from 3.1 million in 2006, before the acquisition of the Chicago Board of Trade -- which offered products linked to the Fed’s benchmark rate as well as U.S. Treasuries -- closed.

The Fed’s drastic steps to support the U.S. economy -- which, in part, involved cutting the so-called federal funds rate to almost zero -- soon drove traders away. Daily volume dropped to 6.1 million in 2008 and 4.3 million in 2009. The figure recovered to 7 million in 2014, and it averaged 6.8 million in 2015 through Dec. 11.

For CME, activity around a possible rate hike “should not only help offset potential volume weakness but should also continue to drive sentiment around the shares,” Alex Kramm, an analyst at UBS, wrote in a Dec. 2 note to investors. CME’s stock rose 6.8 percent this year through Dec. 14, outperforming the 1.8 percent loss for the Standard & Poor’s 500 Index.

CME shares are increasingly moving with rates. The 120-day correlation between moves in its price and fluctuations in two-year Treasury yields reached 0.55 on Nov. 20, showing the closest relationship since late 2008. (Readings of 1 mean two things are moving in the same direction by the same amount.)

ICE, Nasdaq

That’s a tighter connection than American rivals including Intercontinental Exchange Inc. and Nasdaq Inc. CME’s biggest U.S.-based rival in futures is Intercontinental Exchange, whose rates products are more tied to Europe and thus less related to the Fed’s decision. Nasdaq runs the ESpeed Treasury trading platform.

Not everybody is enamored with CME’s prospects. Peter Lenardos, an RBC Capital Markets analyst, put an “underperform” rating on the stock last week in a report titled “An OverRATEd Growth Story.”

“We disagree with the consensus view that volumes will grow meaningfully in anticipation of and following a fed funds rate hike,” Lenardos wrote.

Automated Traders

CME isn’t the only potential beneficiary from the Fed’s action. For market makers such as Virtu, big macro events like a Fed rate decision are key sources of revenue. The Swiss National Bank in January removed a curb on the franc, prompting historic volatility in the currency. Virtu cited that as a driver of first-quarter profit.

Market makers like Virtu place standing orders to buy or sell, profiting off the difference between bids and offers. During times of uncertainty or turmoil, that difference tends to widen, boosting earnings. Virtu’s profit from trading currencies doubled during the first quarter as the Swiss National Bank’s decision roiled markets.

“Volatility is going to go up,” said David Weiss, a senior analyst at research firm Aite Group. Increased volatility will benefit proprietary trading firms. “They’re going to do real well,” he said.

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