Cautious. That’s something I won’t blame you for being.

I spent some time being cautious on Tuesday. Or talking about being cautious. We’ve seen more than a dozen new highs for equities since June, systematics are nearly maxed out, the seasonal’s about to turn, multiples are rich and so on. And vol’s still low. “Hedge when you can, not when you have to.” Wise words from “an exuberantly bearded” sage, as The New York Times recently described the one and only Charlie McElligott.

Speaking of Charlie, hedging and caution, McElligott sent around an updated version of his annotated skew history on Wednesday. Skew, you’re reminded, has a story to tell.

In stylized terms, you don’t need to protect downside on exposure you don’t have. You don’t hedge what you don’t own. Skew’s a measure of relative demand for protection. When it’s flat — or flattening — that’s evidence of waning demand for whatever it is you’re looking at, typically relative demand for puts versus calls. When it’s steep — or steepening — the opposite.

So, when would skew tend to be steep, all else equal? Well, when you have a lot of exposure that needs hedging. In the post-GFC era, investors were encouraged to be long assets as the tyranny of the acronyms — NIRP, ZIRP and QT — forced them out the risk curve and down the quality ladder in search of yield/return. The resulting long exposure had to be hedged, hence steep skew.

Contrast that to the 2022 experience when policymakers (monetary authorities) needed investors to be short assets so as not to perpetuate a wealth effect that was pushing up services-sector inflation. That environment — defined by a long series of big rate hikes — forced investors out of asset longs and into cash. And what is cash? It’s a de facto at-the-money put. No need to hedge. You don’t have any exposure and your cash Overweight’s a hedge for any exposure you do have. Hence flat skew.

The figure above shows those two regimes (the long assets, steep skew post-GFC regime and the short assets, flat skew 2022 inflation shock regime) as well as a nascent return to steeper skew as policy accommodation once again encourages asset longs and rate cuts make cash less appealing.

“When authorities are signaling for you to ‘gun it,’ you gotta run long, but with that you probably gotta burn some premium against the returns on the underlying longs to hedge some downside, which is why skew has been re-steepening as we rally to all-time highs,” McElligott wrote.

Of course, a corollary is a buildup of latent crash “accelerant” risk. On the other side of long customer equity index puts (long customer VIX calls) are dealer shorts. Those shorts would need to be managed in real time in the event spot/vol moves towards strikes on end users’ positions, and those dealer flows are amplifiers: Conceptually, they have to sell equities into the hole and buy vol into spikes.

For now, it’s enough to note the regime shift. “US equities index skew is largely a function of Fed policy and under Trump 2.0’s pivot back to ‘run-it-hot’ fiscal policy, now further stimulated by the alignment of Fed and Treasury, they’re trying to create a positive wealth effect,” McElligott went on.  That equals “steeper skew because you’ve gotta hedge those chunky risk longs.”