Our adage for the exchange sector is that constituent stocks rise or fall based on:
1.) incremental volatility (vol)
2.) incremental participants (gains or losses in trader counts)
3.) incremental products (new product launches)
While CME Group (CME) and the Intercontinental Exchange (ICE) are consistently launching new products, making both stocks attractive on the long side, CME interest rate futures trading stands to disproportionately benefit from incremental participants spurred on by the Fed’s planned wind-down of its historic positions in Treasuries and MBS. With over $4 trillion in cash holdings of Treasuries and MBS set to be consumed by the world’s largest asset managers, pension funds, and insurance companies, formerly unhedged holdings will now move to a more actively-managed style with futures contracts representing the preferred immunization vehicle for buy-side portfolios.
While most investors employ a crude approach to calculating new hedging activity, mainly by assuming a simple notional futures coverage ratio on cash bond positions and thereby disregarding the true mechanics of a cross-hedge, we have used the more accurate, duration-value-of-a-basis-point (DV01) approach to estimate new activity. In a nutshell, we have analyzed current and historical DV01 of cash Treasuries, simply the dollar value impact of a 1 basis point parallel move in the yield curve on the pricing of cash Treasury bonds, and today’s DV01 of the current cheapest-to-delivery Treasury futures contract. This current hedge ratio stands at 10.8x, as a single basis point move would impact $1 million in cash bonds by $870 while the cheapest-to-deliver futures contract picks up $80 of dollar duration. In sum, $1 million in cash bonds can be currently neutralized by 10.8 futures contracts.
DV01's and hedge ratios have varied historically depending on prevailing monetary policy, economic growth, and political climate. Thus, in our scenario analysis we have used historical DV01 hedging ratios between 8-13x. Our estimates extend across varied proportions of the Fed's portfolio coming to market (focused exclusively on the $1.7 trillion MBS portfolio as Treasury bonds are rarely hedged), in 25 percent increments. Therefore, as the Fed’s MBS holdings are absorbed by the buy-side, the impact on CME's interest rate futures business amounts to +232,000 to +930,000 interest rate contracts per day at current hedge ratios, resulting in an earnings opportunity between +$0.05 and +$0.42 per share on an annual basis. At the highest hedge ratio, trading activity would crest over +1.1 million new interest rate contracts per day, increasing annual EPS by +$0.51 per share. Our calculations are herein:
In addition, the knock-on impact from the Fed unwinding its securities portfolio should also be a rise in volatility. While some investors contend that a secular decline in vol has come about because of "blanket buying" of indices via ETFs, thus altering volatility readings indefinitely, we do not ascribe to this view and instead, point out the decidedly negative historical relationship between the Fed's balance sheet build-up and suppressed market vol. While an exact estimate of vol trajectory is a non-linear function (and hence difficult to forecast), a time-series generally lays out the directional relationship between the two variables (in our charts below, the vol series is inverted on the right axis).
While vol is generally good for exchange volumes at moderate levels, we also remind investors that too much volatility actually winds up as a deterrent, and thus at very high vol, exchange stocks are good shorts. This happens because trading activity at high vol actually recedes, as either trading participants go bankrupt or exposure is reigned in as the same Value-at-Risk or VaR can be captured with small positioning. Thus, slightly higher vol is a boon for trading, but extreme readings crash activity.
Modest volatility increases spur volume; however, violent increases seen in 2008 bring volume trends down substantially:
We put CME Group (CME) shares on our Best Ideas list in June of 2015 at ~$93 per share and outlined both an earnings opportunity and a stock path to all-time highs of $140. CME shares continue to hold a spot on our Best Ideas list; however, valuation and earnings estimates are approaching our long-term objective, and while Fed balance sheet management is a positive, we do not see a cataclysmic earnings opportunity. As such, we are slowly shifting focus to other long positions in ICE, Nasdaq (NDAQ), and CBOE Holdings (CBOE) which have more relative upside in our view. We are staying on our long recommendation with an active Fed and for the hedging opportunity described above for now, but CME stock is getting close to top of cycle earnings on a peak multiple. With 2017 earnings estimates at $4.81 per share and '18 forecasts at $5.33, some expectations for Fed balance sheet management are already baked in.
Hedgeye Exchanges BlackBook - Long CME/Short VIRT
Please let us know of any questions,
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
