By Daniel Bases and Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - Investors turned to the relative safety of the U.S. dollar on Friday as Washington's struggle to come up with a negotiated budget that averts spending cuts and tax increases took a turn for the worse, sparking greater fears of a recession.
Markets fell beginning late on Thursday when the budget plan proposed by the Republican speaker of the U.S. House of Representatives, John Boehner, failed to win support from his own party, increasing the chances the austerity measures kick in and pull the country over the so-called fiscal cliff.
The breakdown in talks creates the perverse circumstance in the currency markets in which the historical safe-haven greenback is boosted over currencies driven most by economic growth, such as the euro and the Australian dollar.
"Ranges have been pretty tight and most of what happened overnight continues to dominate through the thin holiday conditions," said Brian Daingerfield, currency strategist at Royal Bank of Scotland in Stamford, Connecticut.
"Despite the stronger-than-expected U.S. data, we have seen that risk appetite has not been able to rally back and that can be attributed to the overhang of the fiscal cliff," he said.
Data on Friday showed the U.S. economy was surprisingly resilient in November despite the approaching fiscal cliff. Consumer spending hit a three-year high in November, and new factory orders for capital goods outside the defence and aerospace sectors jumped.
In a news conference on Friday, Boehner said it is now up to President Barack Obama and his fellow Democrats in Congress to reach a solution before year end.
Boehner's Plan B, which would have raised taxes only on those earning $1 million or more a year, was rejected by conservative Republicans who adamantly oppose any tax increases.
The dollar index rose 0.39 percent to 79.575. Near-term resistance at the 200-week moving average of around 79.50 was breached as the greenback's rally gathered pace. The dollar rose significantly against growth-linked currencies such as the Australian and New Zealand dollars.
"While the latest developments have not scuttled the possibility of a broader budget agreement being reached, the timing is now very tight and the margin for error even slimmer," said Nick Bennenbroek, head of currency strategy at Wells Fargo Bank in New York.
"Further U.S. dollar strength and foreign currency weakness is possible with the uncertain backdrop likely to persist for at least the next few days."
The euro was down 0.45 percent at $1.3182, its worst daily showing in two weeks. Europe's common currency had been in demand in recent sessions on improved sentiment on euro zone assets and earlier optimism a U.S. budget plan could be reached.
The dollar, meanwhile, lagged the yen, as investors trimmed large short positions against the Japanese currency after the Bank of Japan this week increased its asset purchase program by less than some had expected.
The dollar was down 0.13 percent at 84.25 yen, below its recent 20-month high of 84.62 yen. The euro fell 0.62 percent to 111.05 yen.
Both the dollar and the yen, the most liquid currencies, are likely to be in demand as long as the outcome of the U.S. budget talks remains uncertain. Thin market conditions before the year's end could exacerbate price movements.
IMPLIED VOLS RISE
The Australian dollar traded at its lowest level since December 3, at US$1.0394, before finishing the New York trading session at US$1.0405, down 0.75 percent. The New Zealand dollar dropped 1.2 percent.
In the options market, near-term implied volatility rose as uncertainty about the budget talks grew. Demand to hedge against excessive price swings usually rises during times of financial uncertainty.
One-month implied volatility rose to 7.3, from around 6.8 earlier this week. The rise reflected a jump in the volatility index for European stocks as investors sought to hedge against sharp corrections in share prices.
Traders also reported demand for dollar/yen implied volatilities. One-month dollar/yen volatility rose above 8 vols from around 7 in the middle of the week.
Traders pared bets against the yen, which has been pressured in recent weeks by expectations that a new Japanese government will push the Bank of Japan into more forceful monetary easing.
(Additional reporting by Anirban Nag in London, editing by Chizu Nomiyama and Leslie Adler)