CME Rally Signals Volatility as Tapering Mulled: Credit Markets

The surge in bond market volatility and trading volumes stemming from the prospect of rising interest rates, which JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon called “scary,” has only just begun, based on shares of CME Group Inc.

The owner of the world’s largest derivatives market, which offers contracts that span Eurodollars to Treasury bonds, has risen 52 percent this year, more than any other financial firm. Chicago-based CME Group gained 22 percent since Federal Reserve Chairman Ben S. Bernanke suggested on May 22 the central bank could begin to reduce its $85 billion in monthly mortgage bond and Treasuries purchases.

“That’s the equivalent of opening the barn door and letting the horses out,” Brad Hintz, an analyst at Sanford C. Bernstein & Co., said in a telephone interview, referring to Bernanke’s comments. “The actual movement of U.S. interest rates does not have to occur for CME’s revenues to increase,” the analyst, ranked second-best last year in covering brokerage firms and exchanges by Institutional Investor magazine, wrote in a June 17 note to clients.

Speculation over rising rates, which push bond prices down, handed high-grade debt its largest monthly loss in more than four years in May and has led investors to increase hedges and to trade in the futures market, boosting volume on CME’s exchanges. Volatility, a measure of price swings, rose to a one-year high of 84.8 on June 6, according to the Bank of America Merrill Lynch MOVE index. The gauge, which is based on over-the-counter Treasury options, has averaged 62.2 in the past year.

Trading Activity

CME Group said average daily trading in interest-rate futures and options at its exchanges rose to 7.8 million contracts last month, closing in on the all-time record of 9.8 million trades reached in August 2007. Trading fell to a low of 2.7 million a day in December 2008 after the Fed’s policy of near-zero interest rates reduced the need for investors to hedge or speculate with futures contracts.

Michael Shore, a CME Group spokesman, declined to comment on volatility or volume projections, citing company policy.

Global markets will face increased volatility as central banks bring interest rates back to normal levels, JPMorgan’s Dimon said June 6 at the Fortune Global Forum in Chengdu, China.

“We should all hope for a normalization of interest rates, that’s a good thing,” Dimon said during a panel discussion. “As we go back to normal, it’s going to be scary, and it’s going to be kind of volatile.”

Bond Loss

CME Group rose 1.17 percent to $77.28 yesterday, before falling to $76.29 as of 11:18 a.m. in New York. The Standard & Poor’s 500 Financials Index rose 0.62 percent yesterday and has gained 22 percent this year.

What’s been good for CME Group has had the opposite effect on bond investors. Dollar-denominated, investment-grade bonds have declined 0.85 percent this month, according to Bank of America Merrill Lynch index data. That followed May’s drop of 2.3 percent, the largest loss since a 7.4 percent decline in October 2008.

Yields on global corporate and high-yield debt have increased to 3.51 percent from a record-low 3.09 percent on May 2, Bank of America Merrill Lynch index data show. The six-week surge marks the longest stretch of increases since October 2008, following the collapse of Lehman Brothers Holdings Inc. that plunged financial markets into their worst crisis since the Great Depression.

Swap Spread

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, increased 0.1 basis point to a mid-price of 81.9 basis points as of 11:17 a.m. in New York, according to prices compiled by Bloomberg.

The index typically rises as investor confidence deteriorates and falls as it improves. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, increased 0.38 basis point to 16.28 basis points as of 11:17 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

GE Bonds

Bonds of General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 5.2 percent of the volume of dealer trades of $1 million or more as of 11:14 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The Bloomberg Global Investment Grade Corporate Bond Index has gained 0.61 percent this month, paring the decline for the year to 1.17 percent.

The Federal Open Market Committee began a two-day policy meeting yesterday, with Bernanke scheduled to hold a news conference today. Investors are speculating when the central bank will move to change its monetary policy, which has suppressed interest rates.

“An inactive Fed hasn’t been good for rates trading,” Niamh Alexander, an analyst at KBW Inc. in New York, said in a telephone interview. “An environment where you don’t have much movement in rates means you don’t have to hedge.”

CME Group, formed in 2007 by the Chicago Mercantile Exchange’s acquisition of the Chicago Board of Trade, is the 12th best performer in the S&P 500 this year through yesterday, Bloomberg data show. Since May 21, the day before Bernanke’s comments, it’s the third-biggest gainer.

Bernstein’s Hintz raised his adjusted earnings-per-share estimate on June 17 by 10 cents to $3.26 for 2013 and to $3.86 for 2014, Bloomberg data show.

‘Near Monopoly’

The company united trading of short- and long-dated futures with the 2007 combination of the two dominant Chicago derivatives markets. The Chicago Merc was home to Eurodollar trading while the Board of Trade developed U.S. Treasury bond futures. In 2008, CME Group bought the New York Mercantile Exchange, giving it contracts in energy and metals. It controls about 98 percent of all U.S. futures trading.

“Despite being a near monopoly with substantial barriers to entry to new competition, post crisis, the CME was not able to achieve the volume growth needed to support” the growth estimates investors had come to expect, Hintz wrote in the note.

The rise in rate volatility will make interest-rate contracts the biggest revenue generator in the second quarter at CME Group, ahead of energy contracts, said Richard Repetto, an analyst at Sandler O’Neill & Partners LP.

Rising Volatility

CME Group was hit hard by the financial crisis, when its shares, which it split five-for-one in July last year, fell to a low of $31.31 on Nov. 20, 2008, after reaching a record $142.15 on Dec. 21, 2007.

As the crisis unfolded, “clients pulled back on hedging, hedge fund activity levels fell and the industry de-risked,” Hintz wrote in the note. With volatility now on the rise, that’s no longer the case, he said.

“CME’s the bet on the recovering U.S. economy and differing monetary policies around the world,” he said in the interview. He added that once the Fed actually does raise rates, the company should see another boost in its share price. “There’s the smart money that anticipates rates moves and hedges themselves” by buying futures, Hintz said. “And then there are the guys who say, ‘Oops, I forgot,’ and then they hedge.”

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