The Market Reaction to the Washington Impasse Is Chillingly Complacent

08/10/2013 12:35 BST | Updated 07/12/2013 10:12 GMT

The government of the world's largest economy is shut down and the current debt limit of $16.699 trillion was expended in May. Since then the US Treasury has only managed to keep the show on the road by using what it calls 'extraordinary measures', but even they will all have been exhausted by 17th October, (ish).

It now looks increasingly likely that the two questions of passing the Continuing Resolution Bill to allow the government to keep spending money, and raising the debt ceiling, so that the US can repay principal and interest as they become due on current debt, and subsequently issue yet more IOU's, will become co-mingled.

The trouble is that there is now a three party system in the States; Democrats, Republicans and the Tea Party, and the latter seem to have become almost impossible for House Speaker Boehner to rule, as evidenced by their insistence that the Continuing Resolution Bill was sent to the Senate only following the addition of amendments that would de-fund President Obama's cherished Affordable Healthcare Act. Amendments that stood zero chance of ever getting through the Democratic controlled Senate. They were only ever an exercise in band-standing designed for the consumption of Tea Party constituents.

The moderate wing of the Republican Party is now livid with the Tea Party-one gathers Republican Senators fired a volley of angry questions at prominent Tea Party member Ted Cruz, (he of the recent 21-hour filibuster on this matter), their main point being to ask what is his overall strategy, how did he ever think in a million years that he or the Republicans as a whole would come out of this in better shape for next year's mid-term Congressional elections?

In the chilling words of Vanderbilt University public policy professor Bruce Oppenheimer, 'The thing that's different about these Republicans, (the Tea Party), is their unwillingness to bargain," and "I'm not sure if it's because they lack government experience or they've made such strong promises to their constituencies, but they've put their feet in cement and can't or won't move."

How will this end?

Very probably with Boehner leading enough Republicans into a deal to vote with Democrats to get the requisite legislation through, even if this contravenes a party policy known as the "Hastert rule" which prevents a bill getting to the floor that doesn't command majority Republican support. Between here and there we very probably face days of uncertainty and the ebb and flow of news seeping out from closed-door negotiations. There are both hopeful and frightening pointers as how the debate might progress.

Mitigating against a swift resolution is the lack of public angst about the crisis, thus far. Just before the shutdown, a Quinnipiac University poll found 49% of Republicans in favour of a shutdown to block the health law, while 44% opposed it, and after the shutdown began a CBS News poll asked a similar question and found little change, with 48% of Republicans in support and 49% opposed. If the voters don't mind, the politicians won't.

A further disturbing factor was the Treasury's perhaps naïve assurance that in fact Oct 17th isn't a firm deadline, as they can russle up another $30bn to keep things going to the end of the month. Negotiations only reach successful outcomes when both sides feel under enough pressure to ensure an agreement.

More positively, and perhaps importantly, apparently debate between mainstream Republicans and Democrats, including the President , remains cordial and constructive.

In all probability a desire to limit the electoral damage that must surely ensue if the Republicans emerge from this debacle with the most blood on their hands will inspire Speaker Boehner to combine the Continuing Resolution with the debt ceiling increase next week into an all-encompassing 'clean bill', devoid of amendments which render it unpalatable to the Senate Democratic majority.

What I find most chilling, however, is the markets insouciance towards the whole debate, especially the debt ceiling. The Vix Index of equity market volatility, the so-called 'Fear Index', is languishing at 17, whereas it reached 48 during the last debt ceiling impasse in August 2011, as the S and P 500 Index fell 15% in a matter of days. Admittedly simultaneously the Eurozone crisis had markets on the edge then, but one gets the distinct feeling that everyone now believes there will be eventual agreement, and sees any dip in prices as a chance to buy stocks, or is sitting comfortably overweight.

It's fair to say that markets always cause the most pain they possibly can and there are several outcomes that would leave traders in disarray. A quick resolution, before the deadlines, with no preceding dip, would leave some sitting on too much cash and we could see a swift rally, as these traders chase the market.

I am far more afraid of the opposite; in a world where everyone thinks a solution will be found, but actually has no idea how, there is a distinct chance that before this is over the markets suddenly wake up to the gravity of the risks involved and suffer a very significant pull-back, if not a crash, one which may be exacerbated by dip-buyers who then lose their nerve, as prices keep falling.

If nothing else, the VIX Index sure looks cheap.