With only 2 more weeks to go before the end of the year, there still hasn’t been any major progress on the Fiscal Cliff talks. This weekend, there were reports that President Obama plans to reject a new proposal from House Speaker Boehner that some say involve a tax cut extension to all Americans earning $1,000,000 or less. Obama previously called this proposal unacceptable and his stance hasn’t changed. The clock is ticking and if a deal is not reached by this Friday, we could see a wave of deleveraging sweep over the market as traders and investors reduce their exposure and hedge their positions ahead of the holidays. The market tends to be extremely quiet between Christmas and New Years because many traders take the time off to spend with their families. If they want a peaceful vacation that does not involve checking their trading screens every day or every few hours, they will look to cut or hedge their positions this week. For the FX market, this should mean profit taking on long EUR/USD and USD/JPY positions as well as a general reduction in exposure to high beta currencies because if Congress allows the U.S. economy to fall off the cliff, we can expect broad based weakness in the FX market. While the U.S. is the main source of the uncertainty and problems, safe haven currencies such as the dollar and the Yen could be the best performers in the event that a deal is not sealed by the end of the year.

But Congress is no Stranger to Last Minute Deals

This is the biggest budget showdown since 1995/1996 (Clinton years) and a compromise won’t come easy but given the stakes, we still expect a benign partial deal at the eleventh hour that involves closing loopholes, limiting deductions and extending Bush era tax cuts for low to middle income households. Congress is not a stranger to 11th hour deals. Last year, House Republicans held out until Friday December 23rd, 2 days before Christmas to approve the payroll tax cut extension. Two years before that, the Senate worked until the early hours of Christmas Eve to pass an initial version of the healthcare reform. Given the significance of the Fiscal Cliff and severity of the consequences, a last minute announcement of a partial deal days and possibly even hours before Christmas is still a likely scenario.

How FX traders should position for the Fiscal Cliff will depend on how much faith you have on Congress. If you believe that Congress will continue to play hardball with each other and allow the economy to fall off the cliff, then it may be worthwhile to consider reducing or hedging risky forex positions this week. If the tax cuts and reduction in government spending expire, GDP growth could contract as much as 3% in the first half of 2013 and rating agencies have warned about the possibility of downgrades if that were to happen. Even if you believe that the U.S. government will announce a partial deal before December 31st that includes a commitment to a credible deficit reduction plan early next year, it may still be prudent to reduce some exposure because the reality is that Republicans and Democrats remain miles apart. If a credible Fiscal Cliff deal is reached, there should be plenty of opportunity to join a rally that could last for days and even weeks. Some analysts believe that the U.S. economy could handle a brief tumble off the cliff because tax hikes will be felt gradually and while this may be true, the psychological impact and the fear of the consequencs should still drive currencies and equities lower.