> the result is  C -> A -> B -> C

Did you mean C -> A -> B?

By the way, if you applied to this example your reasoning that PyErr_SetObject shouldn't try to fix user bugs, should this example instead be C -> A -> B -> C -> ... (leaving the cycle as is but just not hanging)? Is it not being changed then because the reasoning doesn't apply, or because we're restricted in what we can do by backwards compatibility?