By Saqib Iqbal Ahmed and Laura Matthews

NEW YORK (Reuters) -Growing risks to the U.S. stock rally are spurring demand for portfolio hedging, options markets showed, as investors grapple with U.S. economic uncertainty, shifting Federal Reserve policy and a looming presidential election.

As the spotlight turns toward Tuesday’s high-stakes televised debate between Democrat Kamala Harris and Republican Donald Trump, the Cboe Volatility Index is hovering around 20. That compares with a 2024 average of 14.8 for the index, which measures demand for protection against stock swings.

The VIX typically rises around 25% between July and November in election years, as investors sharpen their focus on the market implications of candidates’ policy proposals, BofA data showed.

This year, however, political concerns have coalesced with more pressing catalysts for volatility, such as worries over a potentially softening U.S. economy and uncertainty over how deeply the Fed will need to cut interest rates, investors said. The S&P 500 notched its worst weekly percentage loss since March 2023 last week after a second-straight underwhelming jobs report, though the index is still up nearly 15% this year. The Fed meets on Sept. 17-18.

“This is an uncertain market,” said Matt Thompson, co-portfolio manager at Little Harbor Advisors. “The market is essentially saying, we know risk is elevated, but … we don’t know what the problem is going to be.”

With volatility already percolating, the “election bump” in October VIX futures, which also encompass the Nov. 5 vote, is smaller than in previous years. On Tuesday, they traded at 19.47, just over 1 point above the September contracts. The gap between the contracts with the highest and lowest volatilities was about 1.4 volatility points.

In the 2020 and 2016 election cycles, the futures curve presented a 7.3 and 3.4 point gap, respectively, between the months with the highest and lowest volatility, a Reuters analysis of LSEG data showed.

That’s not to say politics haven’t had any impact on markets this year. A June debate saw a disastrous performance by President Joe Biden boost bets on a Trump win, fueling rallies in corners of the U.S. equity market that could benefit from Trump policies such as such as tax cuts and regulatory easing, including small caps and energy shares.

Many of those “Trump trades” abated after Harris replaced Biden as the Democratic contender and the candidates’ standings in polls narrowed.

“Because there is no obvious frontrunner in the polls, Tuesday’s debate will be important in terms of lending clues to who the eventual winner may be, which of course has market and policy implications,” said David Bahnsen, chief investment officer at The Bahnsen Group, in a Monday note.

SPEED BUMPS AHEAD?

The VIX has been in sharp focus for investors in recent weeks after the index posted its largest ever one-day spike on Aug. 5, during a sharp market sell-off spurred by economic worries and an unwinding of the global yen carry trade. 

Though volatility took only days to subside, the index has crept up again as markets have grown choppy again in recent days. Societe Generale analysts advised investors on Monday to stay hedged for the next three to six months, warning of possible volatility from economic surprises and geopolitical factors, including the U.S. election.

Others, however, see reasons why investors are less nervous about election risks this time around. 

Stocks have done well under both Trump and Biden, noted Seth Hickle, managing partner at Mindset Wealth Management. With Harris’ policies seen as sticking close to Biden’s, either candidate’s victory does not present a major challenge to investors.

“We don’t really have a whole lot of uncertainty when it comes to what’s going to change. I don’t think it really spooks the market because we have already been through it,” Hickle said.

POLICY DETAILS

Investors on Tuesday night will be looking for details on everything from deficit spending and clean energy to tax policy.

Trump has promised lower corporate taxes and a tougher stance on trade and tariffs. He has also said a strong dollar hurts the U.S., though some analysts believe his policies could spur inflation and eventually buoy the currency.

Harris last month outlined plans to raise the corporate tax rate to 28% from 21%.

Clean-energy initiatives launched under Biden may continue under a Harris administration, potentially boosting shares of solar companies, which have faced headwinds from elevated U.S. interest rates. Some analysts believe her push to lower drug prices may weigh on healthcare stocks.

With uncertainty swirling over the U.S. economy and Fed policy, investors might have a narrow range of pure election trades to target in coming days, according to strategists at Citi.

“Once the Fed decision is out of the way, election trades may become broader again,” they wrote.

(Reporting by Saqib Iqbal Ahmed and Laura Matthews; Editing by Ira Iosebashvili, Richard Chang and Nick Zieminski)

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