Retail sales and producer prices both contracted in the month of December, leading many traders to wonder whether the US economy will fall into recession. Spending on cars, electronics, furniture, gas station receipts, building materials, clothing and sporting goods all declined, reflecting a broad based slowdown in consumer demand. According to Bloomberg News, this is the worst year for US retailers since 2002. With the growth in the labor market already slowing, will the drop in consumer spending push the US economy into a recession and if so, what does this mean for the US dollar?

Is the US Dollar Headed for More Losses?

Before discussing whether the US economy will fall into a recession or how much the Federal Reserve will lower interest rates, it is important to talk about what is in store for the US dollar. Despite weak retail sales and producer prices, the dollar did not weaken across the board today. In fact, it strengthened against the Euro, Australian and New Zealand dollars while selling off only against the Japanese Yen, British Pound and Canadian Dollars. The main reason for this price action is because the weak data has caused a sharp rise in risk aversion. The Dow dropped as much as 275 points today, triggering massive carry trade liquidation. Over the past few years, the AUD/USD, NZD/USD and to some degree also the EUR/USD all were bought for carry trades. However the latest wave of weakness in the high yielders may actually provide good buying opportunities if the dollar continues to weaken. As the Federal Reserve lowers interest rates, stability should be restored in the financial markets, allowing the currencies of countries with strong fundamentals and inflation pressures to appreciate once again. One great example is the Australian dollar. A tight labor market, rising consumer demand, higher inflation pressures and $900 gold prices all point to medium term gains for the currency. The only reason why it sold off today is because of carry trade liquidation. USD/JPY could also extend its fall because Japan will not able to raise interest rates if US growth slows materially.

Recession or No Recession?

As for the US economy, although some economists will argue that the US economy is already in a recession, we do not agree. The definition of a recession is two consecutive quarters of negative GDP growth and in the last two quarters, GDP growth was strong. Even if the economy contracted in the fourth quarter, that would be one quarter of negative growth, not two. The first quarter has just started so it is too early to tell how the US economy will fare. Also, retail sales were bad but spending has been very volatile. Back in June and January of 2007, spending also contracted after a month of solid growth. Retail sales in November increased 1.0 percent which means that part of the decline in December was payback for the strong numbers. The Federal Reserve has the power to determine whether the US economy falls into a recession. If they step up to the plate now they can still prevent the slowdown from worsening.

50bp Is a Band-aid

The futures market has completely priced in a 50bp rate cut, but this may only be a band-aid for a growing problem. Long term yields have remained stubbornly high and even though they will fall on a half point rate cut, the relief to borrowers may be minimal. The Federal Reserve really needs to act aggressively to restore confidence in the financial markets and to stabilize the economy. This means that either an interest rates cut now (yes, that would be an inter-meeting rate cut) or 75bp of easing at the end of the month. The goal is to send let the markets know that the Fed is not playing around and will do everything in their power to prevent a recession from happening. With producer prices falling, the Federal Reserve actually has the flexibility to make a larger move. Yesterday the Baltic Dry Index had its largest two day decline on record. The index is usually used as a measure for global commodity demand and the fall suggests that demand is slowing, which should relieve some of the upside pressure on commodity prices.

But Will the Federal Reserve Really Cut by 75bp?

Probably not.

Since Bernanke’s term as Fed Chairman began in 2006, we have seen no surprises from the central bank. They have always done exactly what the market expected. Even though growth is clearly slowing, inflation risks are still to the upside. Bernanke is a hawk by nature which means that it will be difficult for him to take any measures that risks stoking inflation in an environment where the US dollar is already pushing prices pressures higher. Also, there has only been one 75bp rate hike in the past 15 years, the last time that interest rates were reduced by more than 50bp at a single meeting was in 1984, after former Fed Chairman Paul Volcker had taken interest rates to a high of 20 percent to tame double digit inflation. By raising interest rates as aggressively as he did, Volcker managed to bring inflation down from its peak of 13.5 percent in 1981 to 3.2 percent by 1983. We are not coming off double digit interest rates or even high single digit interest rates at the moment which means that a more aggressive move may be off the radar for Team Bernanke.

Expect the January 30 Federal Reserve interest rate decision to be an interesting one. The market is currently pricing in a 50 percent for a 75bp interest rate cut. However as we have all seen, market expectations can change quickly. Bernanke will be giving his congressional testimony on January 17th while President Bush is slated to deliver his State of the Union address on January 28th. It will be difficult for the Fed Chairman not to shed more light on his plans for monetary policy. As for the President, there is a decent chance that we could see new policy proposals like tax rebates aimed to stimulate the economy.

In the meantime, once the US equity market stabilizes, broad based dollar weakness could resume. The highest probability trades will be to sell the dollar against the currencies of countries that are still looking to raise interest rates or to keep them unchanged.

Antonio Sousa is a Currency Analyst for FXCM.