NEW YORK (Reuters) - The dollar rose against major currencies on Monday, buoyed by uncertainty about U.S. budget talks, while the yen tumbled to a 20-month low after Japan's incoming prime minister stepped up pressure on the Bank of Japan to easy monetary policy.
Volatility could increase as the year-end deadline on the U.S. "fiscal cliff" approaches with little progress on reaching a deal to avoid $600 billion in tax hikes and spending cuts that could tip the U.S. economy back into recession.
A deal in the coming days could spark a rally in currencies like the euro, the Australian and Canadian dollars as investor appetite for risk increases, while no deal may spur demand for the safe-haven U.S. dollar and Japanese yen, analysts said.
"The end of the week therefore sets up as possible volatility event for the market with some analysts expecting a 1 percent rally for risk FX if a deal looks to be done, but a possible severe selloff of 2 percent or more if it fails to materialize," said Boris Schlossberg, managing director of FX strategy at BK Asset Management in New York.
"The risks are skewed to the downside as market remains complacent about a compromise, but for now traders are betting that a deal gets done."
Many investors opted to stay on the sidelines in thin pre-holiday trading on Monday, awaiting headlines from Washington.
The Democratic president and Republican House of Representatives Speaker John Boehner, the two key negotiators, are not talking and are out of town for the Christmas holidays. Congress is in recess, and will have only a few days next week to act before January 1. Some lawmakers voiced concern that the country would go over the "cliff".
The dollar index .DXY, which tracks the greenback versus a basket of six currencies, was up slightly at 79.655.
The dollar rallied 0.7 percent to 84.82 yen, having risen as high as 84.87 yen, according to Reuters data, the best level since April 2011. Chartists said the dollar must overcome 85.05 yen, its 200-week moving average, to sustain further gains.
Shinzo Abe, who is set to become prime minister on Wednesday, renewed pressure on the BOJ to adopt a higher inflation target. Abe said he would try to revise a law guaranteeing the BoJ's independence if his demand for a binding 2 percent inflation target - double its current goal - is not met.
He also said he will pick someone who agrees with his views on the need for bolder monetary easing to succeed BOJ Governor Masaaki Shirakawa when his term expires in April next year.
"The market is really saying they are convinced on yen weakness and that is what we are going to see for the remainder of this year and in the course of next year," said Peter Kinsella, currency strategist at Commerzbank.
The euro was little changed at $1.3184. Offers were cited above $1.3240. It hit a more than eight-month high of $1.3308 last Wednesday as the euro zone debt crisis showed signs of improvement. It rose 0.7 percent to 111.83 yen, not far from a 16-month high of 112.49 yen hit on December 19.
Strategists said developments on the Italian elections and Greece could see the euro grind higher in thin year-end trading. However, if an impasse over the so-called U.S. "fiscal cliff" deepens, investors could sell it for the more liquid dollar.
Marc Chandler, global head of FX strategy at Brown Brothers Harriman in New York, believes the U.S. government will go over the cliff in January, but a deal will be worked out eventually.
Karl Schamotta, senior strategist at Western Union Business Solutions in Calgary, said "the 'cliff' is something of a misnomer." He said if no deal is reached before the New Year, adjustments will be phased in over time, meaning that the fundamental effect is likely to be smaller than many fear.
That doesn't mean that markets aren't facing significant risks and investors "will be forced to protect themselves en masse," he said.
"This could have a major impact in the foreign exchange world, as traders buy perceived safe havens like the dollar and the yen, while selling more sensitive currencies like the Canadian and Aussie dollars," he said.
(Additional reporting by Gertrude Chavez-Dreyfuss; Editing by Peter Galloway)