“I’m just waiting for an update on skew.”

So said one reader last week. That may not be a verbatim quote (I can’t find the comment now), but it’s close.

I’ve been doing this (pontificating daily on markets, macro and monetary policy) for a long time in my current incarnation, and even longer if you include previous “lives.” In all those years, I’m not sure I’ve ever heard a “bystander” (if you will) express so much interest in what, among the unordained anyway, counts as a relatively obscure metric.

I feel like I should apologize: If updates on options pricing are something you look forward to now, and if that state of affairs is in any way my fault, I send my sincere condolences.

Jokes aside, I’ve certainly gone out of my way over the last four of five months to paraphrase and otherwise highlight key excerpts from the tale of pancaked skew, as expounded almost daily by Nomura’s Charlie McElligott.

This is actually a longer story which in many ways encapsulates the tale of the Fed’s post-Lehman experiment in ultra-accommodative monetary policy. Allow me to briefly recap recent dynamics before panning out to the bigger picture.

Market participants who, in many cases, were underexposed to the rally off the October 2023 lows were inclined to grab for upside optionality into the burgeoning melt-up. Over the same period, investors exhibited almost no interest in downside protection. In simple terms: You don’t need to hedge downside for exposure you don’t have, but you do need to participate in the rally somehow. That juxtaposition pushed various measures of relative options demand to extremes, typified by very flat skew and put skew and very steep call skew.

Over the past several days, skew (and put skew) woke up amid some nascent tension across markets tied to the ongoing repricing of the Fed trajectory. I talked about that briefly on Monday here.

On Tuesday, in a very good update, McElligott provided some historical context, both for the prolonged period of “flatness” and what tends to happen in a re-steepening scenario.

“Just to set some baseline context, the last time skew was this flat consistently for at least a month was November 23, 2022,” he wrote, noting that the average skew level last month ranked 2%ile on a near 25-year lookback. The (very) recent steepening pushed skew back up to levels that count as 26%ile on the same window.

The figure above includes great annotations from Charlie. “As I’ve mentioned over the years, the concept of S&P index options skew is in my eyes linked to Fed policy regimes,” he wrote. “[It’s] a function of ‘demand for assets = demand for hedging.'”

If you’re familiar with all of this, you don’t need a lot of additional color. For those unfamiliar, I’ll elaborate on the message from Charlie’s annotations, which serve as a summary of the longer story mentioned above.

When the Fed was engaged in QE, investors were herded into assets of all kinds, and particularly into riskier assets, as monetary policy forced everyone out the risk curve and down the quality ladder in an increasingly desperate hunt for yield. All of that exposure needed to be hedged, hence steep skew.

Once the Fed started hiking rates to curb inflation, the message to markets was the opposite: Investors were discouraged from owning assets as the Fed worked to kill the wealth effect in the service of beating back inflation. As exposure receded and cash levels rose, hedging needs diminished (cash, after all, is a de facto ATM put), precipitating flatter skew.

Now, we may be seeing the regime shift again as skew steepens off the extremes following exposure builds seen during the recent rally to records on various equity benchmarks.

What does history say about setups like the one we’re in now? Specifically, what happened in the past when skew was as flat as it was recently for at least a month and then perked up commensurate with the scope of the recent steepening?

The table above shows you the backtest. If past is prologue, the forwards aren’t especially auspicious.

Outside of 2022, there’s not much in the way of “recent” history. During that (the 2022) analogue, “we saw market indigestion with SPX chopping nowhere” out one and three months, McElligott wrote.

Note that the “trigger” before the 2022 hit was “a doozy of a date,” as Charlie put it: October 15, 2008.