Markets caught a severe case of post-election jitters about the fiscal cliff and sent the dollar soaring - only to see it reverse course on hopes that a resolution to the Washington gridlock is at hand.
If only it were that simple, says David Woo, global head of rates and currency research at Bank of America Merrill Lynch .
Woo argues that markets are underestimating how much fiscal tightening may lie ahead.
(Read more: What Is the Fiscal Cliff? CNBC Explains)
"A divided Washington may make painful fiscal tightening more palatable politically by making both parties share the blame," he wrote in a note to clients. Woo notes that in a late 1980s round of fiscal tightening, the move happened in a divided Washington, when even President George H.W. Bush, famous for his "read my lips: no new taxes" pledge, agreed to a tax hike.
This time around, Woo argues, markets are overly focused on small signs of progress toward a deal on tax levels for the wealthy. He says there are plenty of other areas of disagreement, and "we are concerned that if the Republicans were to capitulate on this issue, they may become more intransigent on other more crucial aspects of the cliff, like the payroll tax cuts and the sequester."
All in all, Woo expects the fiscal tightening in 2013 to outpace that of 1990 or 1993, and with Europe poised to tighten and interest rates near historic lows, there are few offsets in sight.
So how does Woo suggest you trade his gloomy view?
"We expect the USD and Treasuries to do well until either the crisis has been resolved or at least more adequate fiscal cliff risk premium has been priced into financial markets," he says. In contrast, he notes that many Asian currencies have been rising, with China's yuan a case in point - and he thinks investors may be underestimating the potential negative effects of U.S. fiscal tightening on the Chinese economy.
"We think long USD/CNY position is a very cheap way to play for US fiscal cliff risk," Woo says.
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