The recent cloudburst of higher interest rates has turned world stock and bond markets soggy with fears of an economic slowdown and swamped bond portfolios. Yet, off to the side, a small group of companies stand sheltered and smirking, comfortable beneficiaries of the approaching prospect of higher rates and jumpy bond markets.
Discount brokerage firms, derivatives exchanges and managers of money-market funds have lured the investor cash fleeing more traditional financial stocks, whose businesses could take at least an initial hit with the recent lift in interest rates and any more that could come.
Since the start of May, when Treasury yields bottomed and started rising, shares of discount brokers Charles Schwab Corp. (SCHW) and TD Ameritrade Holding Corp. (AMTD), futures exchange CME Group Inc. (CME) and money-market asset manager Federated Investors Inc. (FII) have each soared between 15% and 27%, compared with a flat Standard Poor’s 500 and broader finance-stock sector.
Last week, when Federal Reserve Chairman Ben Bernanke sent the clearest signal yet that the Fed is approaching a point where it might curtail its monthly bond-buying program in response to a steadier economy, financial markets have rushed to price in a “normalization” of interest rates sooner than they had been expecting. The 10-year Treasury yield has surged as high as 2.66% from 1.61% May 1 and 2.18% the day before Bernanke spoke.
While ultra-low rates and the firm expectation that they would stay earth-bound have acted as a de facto subsidy on all manner of borrowing and investor speculation in yield-generating securities, they have also acted as a sort of tax on other activities. Most obviously, they have penalized savers by depriving them of safe income -- something unlikely to change fast.
No longer cheap
For discount brokers and the likes of Federated, which hold huge amounts of customer cash in money-market and other cash-like accounts, zero short-term rates have forced them to waive fees and forgo their usual profits on such funds. Schwab, Ameritrade and Federated have essentially been storing cash for millions of customers at no cost.
While Bernanke’s comments merely addressed when the Fed might conclude its asset-buying program and didn’t change his guidance that actual short-term rates won’t likely rise until 2015, the markets have bid up futures on the overnight federal funds rate controlled by the Fed to price in a boost some time in 2014.
That’s been enough to raise profit expectations for Schwab and Ameritrade appreciably higher. Higher long-term rates, set in the Treasury market, also help as these firms own plain-vanilla banks that reap a spread from the gap between short- and long-term rates. Once short-term rates rise and money-market yields follow, the likes of Schwab and Ameritrade will be able to reinstate their management fees on cash accounts, which is almost all profit.
That being said, both stocks now seem largely to have incorporated the potential value of a rate increase. After their runs, neither is cheap, at or above 20-times expected 2013 profits, leaving the stocks vulnerable to any cooling of the market's rate-rise expectations or slowdown in retail-investor trading activity.
Rich Repetto, an analyst at Sandler O’Neill, has correctly been recommending clients buy Schwab shares during its rise, but the stock is right at his price target of $20 already. He notes that while long-moribund retail-trading volumes picked up in May as the little guy finally seems to have chased stocks higher, his market checks suggest that June activity ebbed yet again.
The calm that hurts
As for CME, the story is simpler, and its opportunity to benefit from a longer period of interest-rate uncertainty is more durable. Its leading Eurodollar futures contract is a principal means that professional investors use to speculate on and hedge future moves in short-term rates, and stands to become tremendously more active as the Fed eyes an “exit.”
What’s more, the exchange’s benchmark S&P 500 index futures are benefiting from an eruption in equity-market volatility. And the CME’s West Texas Intermediate crude-oil products, which had lost market share to Brent oil futures over the past year, have regained popularity.
A glut of oil heading for the Cushing, Okla., WTI hub had depressed WTI prices vs. Brent for technical reasons, spurring refiners to pivot toward the European Brent alternative. Pipeline changes have helped close the spread and return some volume to the CME’s futures array.
CME stock, at $76.04, is also a richly priced 24-times published 2013 forecasts of $3.14 a share. But the emerging volume trends lend a good deal of latent upside to those profit numbers into next year, as the benefit of higher volumes tend to flow straight to the bottom line.
The main risk here is exactly the thing most investors are likely wishing for: Another outbreak of market calm.