* Focus on U.S. budget talks on year's last day of trading
* Highly liquid dollar favored as investors shun risk
* Drastic currency sell-off unlikely if no deal by Wednesday
By Wanfeng Zhou
NEW YORK, Dec 31 The U.S. dollar was little changed against major currencies on Monday, but could gain if lawmakers fail to reach a deal in last-minute talks to avert the U.S. "fiscal cliff."
The Democrat-controlled Senate reconvenes on Monday with only hours to find a legislative solution, most likely a stop-gap deal, that would also have to be passed by the Republican-majority House of Representatives.
On Sunday, Democratic and Republican leaders in the Senate remained at loggerheads, holding their positions, and this soured market sentiment and buoyed the dollar.
"Going over the 'fiscal cliff' is temporarily positive for the U.S. dollar as it drives some risk aversion," said Camilla Sutton, chief FX strategist at Scotia Capital in Toronto.
"However the medium-term impact is U.S. dollar negative," she said. "The combination of aggressive Fed policy, the lack of a credible fiscal plan, a challenged political system and the impact of the fiscal drag should weigh on the dollar."
The euro was down 0.2 percent on the day at $1.3194, with near-term support seen around $1.3142, the Dec. 17 low set on Reuters data. Any euro gains would be capped at $1.3308, the 8-1/2 month high hit on Dec. 19, traders said.
The euro has gained 2 percent against the dollar this year, overcoming worries about a euro zone break-up and a sovereign debt default.
Sentiment towards the euro improved after the European Central Bank pledged to buy bonds of indebted peripheral countries. Positioning data showed speculators sharply reduced bets against the euro in the week ending Dec. 24.
The euro rose 0.5 yen, below a 17-month high of 114.68 yen set on Friday. The euro has risen roughly 15 percent against the yen in 2012, putting it on track for its biggest yearly percentage gain since it was launched in 1999.
The yen held near a two-year low versus the dollar on Monday and was on track for its largest annual drop in seven years, pressured by expectations of more monetary easing by the Bank of Japan.
The dollar was up 0.4 percent on the day at 86.36 yen , but below Friday's high of 86.63 yen set on Reuters data, which was the dollar's strongest level versus the Japanese currency since August 2010.
On the year, the dollar is up 12.2 percent against the yen, the best annual gain since 2005.
With a new Japanese government led by Prime Minister Shinzo Abe expected to pursue a policy mix of aggressive monetary easing and heavy fiscal spending to beat deflation, analysts see the yen staying under pressure in 2013 and any drop in the dollar against the yen likely to be limited.
NO MAJOR SELLOFF
Failure to reach a deal in U.S. budget talks could keep the dollar firm as investors seek refuge in the more liquid U.S. currency. Any progress in talks would be positive for riskier currencies such as the euro and Australian dollar.
While midnight on Monday marks the deadline for a deal, the government can pass legislation in 2013 that retroactively prevents the United States going over the fiscal cliff, an option that is viewed as politically easier.
"The markets have presumed now there will be some sort of a agreement around the middle route," said Neil Mellor, currency strategist at Bank of New York Mellon.
Mellor said a major sell-off in growth-linked currencies on Wednesday, when trading resumes after the New Year's holiday, was unlikely as it would take a few days before volumes rose to normal and investors return with fresh annual allocations.
Many investors say the impact of the fiscal measures will only be felt gradually and that the U.S. economy does not face immediate catastrophe if no deal is reached.
Strategists also said that with budget talks dragging on for months, the lack of a deal by year-end had already been priced in by many investors, limiting the impact of such an outcome.
"The market seems to have almost taken into account the U.S. fiscal cliff discussions will go into the new year and investors seem to have taken off any risk-on positions before the holiday period," said Michael Sneyd, FX strategist at BNP Paribas.