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LONDON (Reuters) - 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 U.S. dollar and Treasury bonds would be among the main beneficiaries, making for a very different dynamic to the euro zone 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 U.S. 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. <MKTS/GLOB>
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 U.S. 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."
Obama and Boehner aim to reach a deal before the New Year, when taxes will automatically rise for nearly all Americans and the government will have to scale back spending on domestic and military programs. The politicians are now in recess until at least December 27.
"The time left to seal a deal is limited," said Kit Juckes at Societe Generale in London.
There is, however, good reason not to panic since the term "fiscal cliff" is somewhat misleading. America will not crash off it on January 1. The tightening process will be more gradual.
The head of G10 FX Strategy at one bank in London said it was much more of a slope than a cliff. "The market's working assumption has been all along that it's going to go right down to the wire, and then they're going to cut a deal."
Hong Hao, Bank of Communications International Securities' chief equity strategist in Hong Kong, said: "If I were a fund manager, I would be looking to lock in gains and going off for the holidays. The U.S. will eventually come to a deal, maybe just not by their self-imposed deadline."
As with the euro debt crisis, the markets could offer a natural check and balance -- if their reaction turns savage, it might pressure a divided Washington to come together.
The difference is that, as with the dollar, U.S. government bonds are viewed as a harbor from risk, so the bond market pressure brought to bear on the euro zone is unlikely to be replicated in this case.
"Although trading at all-time lows, treasury yields could benefit both from renewed equity volatility and the short-term economics after any resolution," said Edward Smith, global strategist at Collins Stewart Wealth Management.
Unlike the euro zone periphery, shunning U.S. assets is not really an option, not least because global markets tend to correlate closely with Wall Street anyway.
For Juckes, the latest standoff in Washington could go two ways: The weakening of Boehner's position could strengthen Obama's hand, particularly since he has already given ground. Alternatively, the Republicans may now be so divided that they cannot back any sort of deal that raises taxes on the wealthier.
The optimists would buy equities and the euro on any dip, he said. "(They) will look at the improving tone to U.S. data and at the vast amount of money that needs investing."
If the glass-half-full view prevails and the world economy starts looking up, Reuters asset allocation polls show major investors are looking to areas that underperformed this year -- notably the Chinese stock market, one of the few major bourses in the red for 2012.
After two years in which the stock markets of the emerging giants underperformed, Russia and Brazil also have backers.
For now, most investors seem to be hoping for the best rather than altering their strategies.
"If it turns out that there's a poor agreement delaying a number of issues until the spring but skating away from the immediate catastrophe of January, or no agreement at all, that clearly is not priced into market expectations," said Andrew Milligan, head of global strategy at Standard Life Investments, which has 163.4 billion pounds of assets under management.
"I think (a lack of agreement) would encourage people even more to go into the dividend yield type stocks ... And clearly the stocks that are more associated with global trade would be the ones that investors would be pulling back from," he said.
Reporting by Sinead Cruise, Sujata Rao, Nia Williams, Tricia Wright, Richard Hubbard and Clement Tan. Editing by Jeremy Gaunt.