While we will shortly present some practical perspectives on what the debt ceiling fiasco due in just about a month, means practically for the economy (think sequester, and another 1% cut to US GDP, which when added to the payroll tax cut expiration's negative 1.5%-2% impact on 2013 GDP, and one wonders just how the US will avoid recession in 2013), here is a must read perspective from Citigroup on how the markets may and likely will react to what is shaping up to be another "12:30th hour" (the New Normal version of the eleventh hour) debt ceiling resolution, which is now under a month away.
From Citi's Steven Englander:
Debt ceiling --- first complacency, then horror
Asset market markets are likely to ignore the debt ceiling till the last minute, or even later, and then react on panic if it gets breached. For FX this means that the risk on trade for EM and G10 risk-correlated currencies may have a month or six weeks to go before there is any indication that FX investors are even aware of what is going on in Washington.
The reason is that the past three fiscal driven sell-offs have had increasingly little market impact. The July 2011 debt ceiling crises + downgrade led to more than 15% drop in US equities (Figure 1, note that EUR was well north of 1.40 till late in August, so this wasn’t a manifestation of the euro crisis). Right after the November 2012 election we had a bout of fiscal cliff worries that gave us a 5% correction, but when talks broke down in late December, equities barely budged. We suspect investors in FX and other markets have become conditioned to last minute resolutions to US fiscal crises and are increasingly jaded with respect to the political process that will generate the solutions. Hence the tendency will be to hold on to risk even longer on the view that ‘don’t worry, something will turn up’, just as it has in the past.
We think this means that 1) risk will sell off less approaching the debt ceiling deadline; 2) currency investors will hold on to risk in spot but buy tail risk hedges; and 3) there will be a wholesale cutting of positions in FX and other asset classes, if the debt ceiling is breached. So it may looks as if the debt ceiling breach is not worrying asset markets, but it means that investors are banking on the chestnuts being pulled out of the fire. If they are not pulled out, positions go up in smoke.
To be clear, it still seems most likely that there will be a short-term extension of the debt ceiling accompanied by automatic sequesters, but if not the consequences will be more severe than will seem to be the case in the run up.
Figure 1.US asset markets become less responsive to fiscal crises: