What's driving VIX futures spread higher?

The focus is on the FOMC meeting this coming week. Market participants, economists, the public  - all want to know if the "taper" is coming. The Google Trends search frequency for "Fed taper" has spiked in recent weeks.

Google Trends phrase "Fed taper" (search frequency over time)

The reduction in securities purchases is however already priced into the market, with the expectations varying between $10bn and $15bn per month. The markets are prepared and are now looking beyond the FOMC meeting. And things are not looking too certain in the next couple of months. The spread between the November and the October (post FOMC period) VIX futures has risen, pointing to expectations of higher volatility ahead.

Where will the markets begin to focus after the FOMC meeting? The situation in Syria of course still runs the risk of causing market havoc globally. But judging by Israel's sovereign CDS spread, it seems that the probability of a US-led military conflict has receded. Prospects for a diplomatic solution or a status quo situation have improved.

And while crude oil prices remain elevated, a great deal of that premium is not due to Syria any more. Instead it is the reduced output from Libya that is keeping prices relatively high (see NYT story, which demonstrates that getting rid of a ruthless dictator does not necessarily improve stability or prosperity).

So if the Middle East is not expected to flare up, why has the VIX futures spread increased so much? Clearly there are a number of other macro risks, but markets are beginning to pay attention to the upcoming budget fight in Washington. And this one has the potential of becoming quite ugly.

CBSNews: - If Congress doesn't send Mr. Obama a spending bill by Sept. 30, the federal government would partially shut down. Quickly after that, Congress will have to raise the nation's debt limit or risk letting the government default on its loans. As these deadlines approach, Democrats and Republicans remain deadlocked over federal spending levels -- lawmakers either want to restore the spending slashed as part of sequestration, or replace the sequester with "smarter" spending cuts.

What could make the debate particularly contentious is the fact that President Obama's approval ratings have slumped recently. House Republicans are running less political risk - and in fact could gain more support from constituents - if they dig in for a fight against what they perceive as a weakened administration. Remembering a similar situation in late summer of 2011, the uncertainty around possible outcomes of such a confrontation certainly has the potential to roil US markets.

Source: Gallup

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