LONDON: Global investors are betting Washington will overcome its budget deadlock despite an apparently serious setback.
If they are wrong, there could be a sharp market reaction and the US dollar and Treasury bonds would be among the main beneficiaries, making for a very different dynamic to the eurozone crisis, where bond market pressure was instrumental in forcing policymakers to act.
Republican lawmakers rejected a proposal on Thursday by their leader, House of Representatives Speaker John Boehner, designed to extract concessions from President Barack Obama.
It threw into disarray attempts to head off $600 billion worth of tax hikes and spending cuts that could push the US economy into recession.
The dollar climbed versus the euro, stocks slid from Tokyo to London and safe haven government bonds rose but in only muted fashion, indicating a continued belief that a deal will be done. Is this sensible or complacent?
Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock, said the only approach was to 'hope for the best, but plan for the worst'.
Given the much greater downside from a fiscal cliff failure than upside from success, we continue to maintain our tactical defensive positioning," Rosenberg said.
If differences between Republicans and Democrats cannot be bridged, the dollar – counter intuitively to the layman's eye — would attract safe haven flows as the world's reserve currency.
The yen could do even better despite the new Japanese government's intent on more forceful monetary and fiscal easing. "The dollar goes up when people get more nervous because the reflex in the market is to assume it's a safe haven, there's very little consideration given to the nature of the crisis," said Daragh Maher, FX strategist at HSBC.
"If the US is heading towards recession it's not good for anyone, therefore if I have to hold something I may as well hold the dollar. That's how the sequence of logic goes."
There is, however, good reason not to panic since the term 'fiscal cliff' is somewhat misleading.