The price action in the financial market over the past week shows that investors are nervous. The simultaneous decline in stocks and rise in the U.S. dollar reflects broad based deleveraging. Investors are cutting back on risk because they are worried about the U.S. Fiscal Cliff. The clock is ticking as the government has approximately 7 weeks to come up with a solution to avoid the cliff or risk plunging the U.S. economy back into recession. There is a tremendous amount of economic data on the calendar this week but the fiscal cliff will continue to loom large.

This is the biggest budget showdown since the 1995/1996 (Clinton years) and a compromise won’t come easy but everyone knows that there is a lot at stake. If they allow the economy to fall off the fiscal cliff – there will be no winners. One side must back off on tax increases for top earners and its still not clear who will give. How FX traders should position for the Fiscal Cliff will depend on their expectations for a resolution by the end of the year. If you believe that Congress can reach compromise to reduce deficit without shocking the economy by December 31st, then you can view the recent strength of the U.S. dollar and Japanese Yen as an opportunity to sell safe haven currencies at higher levels. However if you believe that Democrats and Republicans will continue to play hardball and calling each other’s bluff then adding to defensive or safe haven trades may be the way to go. Either way, a resolution won’t come easy and investors will remain nervous over the next weeks as they wait to see how the discussions in Washington play out. If we get a bipartisan deal on the fiscal cliff, we can expect a strong relief rally in the markets that ease safe haven flows out of the dollar and into riskier currencies. Between now and then however, the odds favor more risk aversion and demand for the U.S. dollar.

The Fiscal Cliff is a big deal because Bush era tax cuts and mandatory discretionary programs are set to expire at this end of the year and if they are not extended, Americans will be hit with hefty tax increases and reduction in government spending that could shave as much as 4% off GDP. This will plunge the U.S. economy back into recession and cause growth to contract as much as 3% in the first half of next year. The consequences of allowing the U.S. economy to fall off the cliff are extremely severe and the stakes are abundantly cleared to all parties involved. To get the ball rolling, House Speaker John Boehner organized a conference call with House Republicans this weekend urging them to compromise with the Democrats.

With only a few more weeks to go before tax cuts on personal income, capital gains and dividends expire negotiations need to start now. Failure to convincingly tackle the fiscal cliff could lead to further weakness and volatility for the financial markets as well as another downgrade of the U.S. debt rating. Fitch warned last week that they would strip the U.S.’ AAA rating if the fiscal cliff is not averted and the debt ceiling isn’t increased in a timely manner. Eliminating loopholes and cutting deductions can help raise revenue and lower the deficit but Democrats and Republicans are deadlocked on entitlement reform and tax increases. While we are hopeful that a credible bipartisan plan will be reached, we are not confident in our expectations. The recent price action in the financial markets tell us that many investors feel the same way and until there is reason for everyone to be more optimistic, defensive trading and deleveraging may continue to drive currency flows.