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It had seemed that many participants were looking past the U.S. fiscal cliff and were to be content taking on more risk. However, yesterday's late developments have provided a cold slap of reality. Our base scenario, under which the U.S. does in fact go over the cliff appears more likely now that Speaker Boehner's "Plan B" failed to draw sufficient Republican support to allow a vote. Indeed, there is some speculation that the failure of Boehner's gambit may see a leadership challenge right after the New Year.

The lack of a coherent Republican strategy has prompted a large unwind of risk-on and thin holiday market conditions may be exacerbating the price action. In the risk-off mode, the U.S. dollar and yen have performed best. The dollar-bloc, which has generally lagged in recent days, remains under pressure.

After approaching $1.06 last week, the Australian dollar approached $1.04 in Asia before finding a bid in Europe. Resistance is seen now near $1.0460. The greenback has moved above CAD0.9900 for the first time in two weeks and may close above its 20-day moving average for the first time in a month. The New Zealand dollar is the weakest of the three. It is off more than 1% on the day. It is off 2 cents on the week. With today's drop, the NZD has retracement nearly 61.8% of the rally from Nov. 16's ~$0.8065 to last week's high near $0.8475.

The European currencies are faring better than the dollar-bloc. Consider that the euro finished last week near $1.3165 and is now at pixel time above $1.32. For its part, sterling finished last week near $1.6175 and now is nearer $1.6240.

There have been a few developments in Europe to note. First, the U.K.'s Q3 GDP was revised slightly lower to 0.9% from 1.0%. On a year-over-year basis, the U.K. economy was flat. Second, Italy's passage of the 2013 budget and the balanced budget law will likely allow the dissolution of parliament over the next few days to allow for a late February election. Monti will deliver an end of the year address in which he is now expected to declare his intention to lead a centrist coalition. Monti appears more popular outside of Italy than within it, but securing 15-20% of the vote could still be decisive. In the meantime, Monti goes from unelected technocrat prime minister to caretaker.

It is not Italy, Spain, or even Greece that is the most pressing case in Europe as the year winds down, but tiny Cyprus. As we have noted before, the focus is on the recapitalization needs of its banks, which overwhelm the government's finances. S&P has slashed its rating for the second time in two months to CCC+ from B and maintains a negative outlook, ostensibly due to its reliance on short-term financing.

The key issue now is that the IMF reportedly is pressing for a restructuring of its debt, which means a private sector haircut. Cyprus may not be Greece and Greece may be unique, but it is difficult to see how Cyprus' debt situation can be put on sustainable footing without a restructuring of its debt. There is some talk of seeking Russia's assistance again, but this only adds to the country's debt burden. As the IIF's Tran notes, the problem with the private sector burden sharing is that the creditors said that the Greek experience would not be repeated.

Turning to Japan, the dollar has once again tested the JPY83.80 area for the third time in four days and it held. The modest gains in the yen appear to be largely a function of unwinding crosses against the dollar-bloc. An LDP spokesperson noted that the BOJ's charter need not be modified if the BOJ capitulates. The BOJ governor, whose term ends in a few months, does not appear sympathetic to a 2% inflation target or open-ended QE.

We have suggested that open-ended QE is more a way to market present the QE rather than substantive. The decision to buy foreign bonds lie with the Ministry of Finance not the central bank. Lastly, we note reports that the LDP does not want to trigger a large slide in the yen's value, but would be content for the dollar to trade in the JPY85-JPY90 range.

Source: Market Discovers Fiscal Cliff, Sends Dollar Higher