By Richard Hubbard
LONDON (Reuters) - The dollar fell and Wall Street was expected to weaken on Thursday as relief over a U.S. budget deal gave way to worries over the effects of the 16-day government shutdown and prospects of a re-run early next year.
The legislation signed overnight by President Barack Obama to fund the government until January 15 and extend a debt ceiling deadline to February 7 did nothing to resolve the differences over spending and deficits that divide Republicans and Democrats.
"The U.S. can give a sigh of relief for now but the New Year could bring a dangerous sense of déjà vu," Luke Bartholomew, investment analyst at Aberdeen Asset Management, said.
Equity markets in the U.S. and Asia initially welcomed the last-minute deal which pulled the world's biggest economy back from the brink of a historic default, but the rally ran out of steam as the longer-term implications sank in.
MSCI world equity index <.MIWD00000PUS>, tracking shares in 45 countries, was up 0.3 percent and close to a five-year high while Europe's broad FTSE Eurofirst 300 index <.FTEU3> had shed 0.15 percent by mid-morning.
U.S. stock index futures also pointed to losses when trading opens.
"Markets had expected the can to be kicked down the road, and the can's been kicked down the road a little bit. We're not really waking up in a radically new world," Bartholomew said.
"Had it all gone wrong, then the market reaction would have been very different."
FISCAL CLIFF II
The temporary nature of the agreement and longer-term worries that the debt ceiling risks would become a structural drag on the economy also weighed on debt markets.
That view was shared by Chinese credit agency Dagong, which downgraded the U.S. sovereign rating to A- from A with a negative outlook, driving further dollar losses.
The 10-year benchmark Treasury note yield slipped to 2.65 percent from around 2.68 percent late in New York. While U.S. Treasury bill futures had gained 0.1 percent.
"It casts dark clouds over the economy - politics are now the main drag for growth in the U.S," Rabobank strategist Philip Marey said.
German government bond prices, which tend to rise in times of uncertainty, tracked the U.S. Treasury market higher as well, sending the 10-year Bund yield down 4.5 basis points to 1.89 percent.
Investors were also responding to the likelihood that the fiscal saga would inevitably delay the start of the Federal Reserve's planned withdrawal of its monetary stimulus.
Markets had expected the Fed to announce in September it would cut its bond purchases. When that didn't happen they switched forecasts to December, and now many anticipate no action until next year.
"We would expect this impasse to shave off part of fourth-quarter growth and hurt consumer confidence, especially from the government sector," said Simon Derrick, head of currency strategy at BNY Mellon. "What this does is push back expectations of Fed tapering to early 2014."
While expectations of a delay in tapering support equities, they tend to weigh heavily on the dollar, not least because the scale of the Fed pullback - when it does occur - far outweighs any changes in monetary policy expected in the euro zone and Japan over the same period.
Against a basket of currencies, the greenback had slipped 0.7 percent to 79.9 <.DXY> having earlier set a one-month high on the initial relief that a full-blown crisis had been averted.
Against the safer alternative of the Japanese yen, the dollar fell 0.75 percent to 98.02 yen, pulling back from an earlier three-week peak of 99.01.
The dollar's broad losses saw the euro rise 0.6 percent to $1.35570 and supported higher-yielding and growth linked currencies including the Australian and New Zealand dollars near recent highs.
The weaker dollar and the likelihood of Fed holding back on reducing its monetary stimulus also gave gold a big lift.
The spot gold price surged to a one-week high just shy of $1,320 per ounce, up more than 2.5 percent on the day. While the December COMEX gold futures contract touched a high of $1,320.50.
"Tapering will be postponed much further, so that's probably the main aspect behind the current spike in prices," Commerzbank analyst Daniel Briesemann said.
Brent crude declined 55 cents to $110.04 a barrel as of 1030 GMT, with investors reluctant to take on fresh positions ahead of a deluge of data expected to emerge as Washington gets back to business.
(Additional reporting by Anirban Nag, Marius Zaharia and Veronica Brown. Editing by John Stonestreet)