There could be several answers to this question, not all of which are contradictory.
Some market participants may believe that one side or the other in the political game of chicken will blink and pull off the road at the last minute (or the minute after the last minute, as happened with the Fiscal cliff drama of New Years Week). It wasn't the president who blinked then, and so it won't likely be Obama this time, which leaves it up the House Tea Party Republicans: but they seem to have convinced themselves that the Sequester is the only way to accomplish any kind of budget cut, or that reductions in the rate of spending increases aren't really "cuts" at all. So they do seem committed to letting the Sequester happen and either blame the president or take credit for the cuts, or both! (Logic never bothers this crowd.)
The two polar opposites on this fight, therefore, seem to be out of the game in terms of any last minute blinking. Why then, could markets expect anything other than a train wreck for the economy already showing signs of recession in the last quarter of negative growth? First of all, the markets don't really believe the last quarters' early estimate of GDP -- and more recent data, like exports, suggest that the markets may be right in expecting an upward revision in of Q4 GDP to positive territory by the end of this month.
Secondly, the markets hold out some hope that the Senate again (as with the Fiscal Cliff) will yield some sort of last-minute maneuver -- perhaps a one-month can-kicking to at least synchronize the Sequester kick-off with the end-of March deadline for a continuing resolution to fund the entire U.S. Government through the summer.
Why not, after all, set up another "perfect storm?" Wouldn't it be just the way Super Storm Sandy taught us: two "lows" colliding over the East Coast to paralyze commerce -- in this case, the "low" of Sequester combined with the "low" of a Government shutdown -- a veritable wish-fulfillment fantasy of the Tea Party. And they could blame all the resulting economic crash-landing on Obama and go on to a glorious victory this November in the presidential election with... oh, wait a minute, the election was last year! But the market may be right that at least putting these two evil twins on the same timetable would get us through another month of capital gains before the shut hits the fan.
Moreover, a one-month "suspension" of the Sequester would give Senate Republicans a chance to cave without actually caving. Because they wouldn't be caught voting for further tax increases (like removing the "carried interest" capital gain treatment for private equity, venture capital and hedge fund managers' performance compensation) -- instead they would be just attempting to make time for a broader solution for spending issues (and maybe a little tax reform), just as they did when they agreed to put off the debt ceiling trigger until at least the end of May. Washington usually likes to cloak deals in "precedent" -- except when it doesn't.
If the Senate actually passed a 30-day Sequester punt (ok, the football season is over, we can get away with a bad metaphor), Boehner might be forced to at least let the House vote on it, and if enough non-Tea- Party Republicans joined with Democrats, as they did on the Fiscal Cliff and Debt Ceiling votes, we could defer the latest Armageddon until late March instead of late February.
The markets may also be betting that President Obama, despite his daily reminders of how the Sequester will force drastic cuts to military readiness, air traffic control, airport security personnel, meat and poultry inspection, food stamps, Head Start, childhood and family nutrition, research into infectious diseases, disaster recovery in the Northeast and elsewhere, school lunches, Veterans benefits processing, and the like, will use his executive authority to defer and deflect these draconian measures for, say, 30 days or so, to produce his own version of deferred Armageddon to bring the whole thing to a head in the context of the "government shutdown" debate coming at the end of March.
Indeed, if history (and the ever-cable TV-present Newt Gingrich) are any guide, the thought of having to defend a government shutdown as well as the Sequestration might send shivers up the spine of just enough Republicans to get them to throw the hedge fund managers over the side and make a deal to get through the rest of the year with some form of "Sequester Lite" that won't trigger a new recession in Q2 and Q3 and that raises just a bit of "loophole closing" tax revenue to create some "balance." They all know that the "carried interest" tax benefit is indefensible anyway and will go as part of any eventual "tax reform" package; Obama will have enough for his victory, but Republicans will not have to worry about being again labeled the Party (Poopers) of 1995 (actually that may give them more credit for modernity than they deserve lately). And the markets will be happy indeed!
Obama then can move on to approving the Keystone Pipeline while closing a bunch of coal-fired power plants, appointed women as Secretaries of Transportation, Commerce, the EPA, and to head the Federal Reserve after Bernanke, and if he's still on a roll signing immigration that passes precisely because it doesn't have his fingerprints on it. (It's a truism that there is no limit to the things you can accomplish when others get to take the credit!) And maybe there will be controls on gun sale procedures and ammunition limits (but these subjects are for another blog).
Right now, the best thing we have going for the stock market is that nobody in Washington truly wants to take ownership of the Sequester -- even the Tea Party will eventually duck this paternity test. The stock markets have seized on such denial of fatherhood with both hands. Little else explains a market up close to all time highs in just the first fifty days of the year. It can't be about the Pope, could it? But there is one forthcoming election in Italy that could upset the market's Apple-less applecart - but that's if Berlusconi wins!