You don’t need to hedge what you don’t own. And vice versa.
That simple, axiomatic observation is key to understanding the post-GFC history of SPX skew.
Let’s pause for a chuckle. Imagine saying that to someone at dinner. Better yet, imagine saying that to someone at dinner unprompted.
“I think I’ll try the tuna carpaccio, what are you going to get?” she asked.
“You don’t need to protect downside on exposure you don’t have,” I replied, leaning in. “That’s key –” I tapped the corner of the menu on the table for emphasis. “– absolutely key to understanding the post-GFC history of SPX skew.”
My point made, I relaxed, leaned back in my chair and answered her question: “I’m going to be adventurous and try the peppercorn crusted elk chop with horseradish spätzle.”
See there? Whenever someone tells me I need to find people who share my current interests, I remind them that my current interests aren’t interesting to people.
Jokes aside, skew “has a story to tell,” as I’m fond of putting it, and that story in many ways encapsulates not only the tale of the Fed’s post-Lehman experiment in ultra-accommodative monetary policy, but also the story of the Fed’s rate-hiking cycle begun in 2022 and, more recently, the pivot back to rate cuts.
The figure above’s a helpful reminder: Through early October, there’d been no central bank rate hikes anywhere in the world for two months on BofA’s count.
With the Fed guaranteed to cut rates again next week, and with exposure to risk assets running fairly high in aggregate (although the breakdown by investor cohort admits of much nuance), it’s worth quickly revisiting the skew tale with the usual tip of the hat to Nomura’s Charlie McElligott who re-upped it in his latest, sent around on Thursday.
When would skew tend to be steep, all else equal? Well, again, 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, updated through mid-week, finds McElligott (re)telling the skew story, including an annotation for the current regime, defined by a re-steepening consistent with central banks’ effort to remove policy restriction and an accompanying fiscal impulse that’s still stimulative, both of which argue for asset longs which in turn need to be hedged.
“With the US government shutdown showing zero signs of ‘give’ right now, as well as real delta of no Trump / Xi meeting, folks aren’t totally abandoning hedges just yet, with SPX three-month skew back up to 81%ile,” Charlie wrote. “Global ‘run hot’ fiscal dominance aligned with easier central bank policies [and more] cuts coming incentives ‘long assets’-positioning that then requires downside protection.”
(I’ll be at The Fig Tree in Charlotte on November 2 at 8:00. I may or may not get that elk chop. If you’re in the area, make a reservation. If you can spot me successfully, I’ll buy you and yours a round of drinks.)
Too easy: you’ll be at the end of the bar drinking coffee. Except now you won’t be.
I won’t be by myself. One of the characters from the Monthlies will be there too.
Unfortunately I can’t make it. Hopefully, next time? I do give myself 10:1 odds (conservatively) that I could identify you. Actually, I think I have a pretty good idea about your dining partner, too. Finally, I give myself 1:1 odds that I could get you to buy me dinner! 🙂
Yeah, I’d buy you dinner.
I have a guy in KC who can do that chop. He also does Elk loin.
Awww, you do love us!
Is there any way to parse out how much of the protection buying is by foreign buyers? That would mimic some of the USD hedging we’ve seen this year.
Oh, when you say “you and yours” do you mean a couple or one’s whole family? Thanks to my religious beliefs, I have two lovely wives and 14 thirsty sons I would bring along if so.
My wife will definitely be having the beets and the sea bass, while I’m going to order escargot (I always get the snails) and the elk chop. See you there!
I’ll be 500 miles away, but you know, in spirit.
Can’t make it, but thanks for the restaurant recommendation!
You’ll find me at the end of the bar, sipping a Gibson, and sampling the oysters. I’ll be the one with the opera glasses trying to spot you. I know not to disturb you, so when I figure it out I will just smile and tap the side of my nose. (Don’t worry, I live more than 2,000 miles away, but I do relish the invitation.)
If I missed this somewhere in an article, I apologize, but just wondering if the 6+ trillion dry powder that had been in money markets and bank accounts has finally made its way into the market? Is that what has been driving the retail buying lately?
That chop sounds divine. As someone who spent 2.5 years living in Shelby, I rarely go back to NC. Beautiful state, but I know that even if I went to meet you, which I’d consider a privilege, I think I’d leave you alone out of respect. Buen provecho while you’re there, H.