UBS - "The fiscal cliff is a collection of spending cuts, tax hikes and unemployment benefit restrictions that will begin at the start of January. The budgetary reductions total a savage $600bn or 4% of GDP. If America's politicians are unable to agree on alternative fiscal policies by December 31, the shock to the economy would tip the US back into recession. It would also trigger ratings downgrades while inducing the Federal Reserve to ramp up its third round of quantitative easing. In short, it could put America's equities, bonds and currency at risk. (...) Given the severity of the fiscal cliff, 'rational' politicians should be able to reach a compromise - otherwise they will be blamed by America's voters. Both President Obama and Republican leader Boehner have signalled they are willing to shift their positions. (...) That will help the dollar - paradoxically - in the short term as US investors will shun riskier foreign markets. Combined with deadlock between Madrid and the European Central Bank and fears over the long term survival of Greece's government, we expect the euro to keep trading lower towards 1.25 against the greenback initially and back to 1.20 in 2013. Other safe haven currencies like the franc and yen should also do well. But dips in USDJPY are set to be limited given increasing pressure on the Bank of Japan.
What would offset near term dollar strength would be an aggressive move by the Federal Open Market Committee at its last meeting of the year on December 11-12 to ease policy further.
(...) We continue to believe that currency markets, having initially pushed the dollar down through 1.30 against the euro in Q3'12, have already priced in the detrimental impact on the greenback of the Fed's new third round of quantitative easing. Instead with the US economy continuing to recover faster than the Eurozone, UK and Japan we expect other major central banks will be easing policy for a lot longer than the Fed."
Mansoor Mohi-uddin, Managing Director and Head of Foreign Exchange Strategy at UBS Macro Research.