US retail sales are due for release on Thursday and the degree of consumer spending could play a big role in determining where the US dollar may head next. Despite continued deterioration in the labor market, economists expect retail sales to have rebounded by 0.5 percent last month after having fallen 0.2 percent the prior month. Excluding autos, sales are expected to rise 0.7 percent compared to a 0.5 percent rise in April. If retail sales are as strong as the market expects, the dollar could hit a 4 month high against the Japanese Yen and extend its gains against the Euro. However, traders have to be careful because even if there is a pickup in consumer spending, Americans are probably only buying what they need and not spending money on any other discretionary items.

Food and Energy: The Biggest Contributor

Unsurprisingly, the surge in food and oil prices are expected to be the primary contributor to higher spending as higher prices have increased the checkout bills for all Americans. Since the beginning of March, the average price of a gallon of gasoline has increased from $3.20 to more than $4 a gallon, due to the $30 surge in crude oil prices. In a private survey, SpendingPulse, which is the retail data service for MasterCard Advisors reported that retail sales excluding autos improved in May as the rise in gasoline spending offset the drop in purchases of other discretionary items.

Retailers: Mixed Bag

Interestingly enough, not all retailers have been suffering. The following data is extracted from Business Wire’s Monthly Retail Report. Food and general merchandise discounters are faring the best with Costco and BJ both reporting a double digit increase in spending. Clothing retailers like Chico’s and The GAP on the other hand have suffered the most. This clearly indicates a shift in spending behavior, where money is spent more on consumer staples than clothing or other luxury items. In times such as these where prices are increasing everywhere and layoffs are rising, it has become crucial for consumers to get the most out of each buck. If such conditions continue to persist, then it is safe to assume that discount stores will continue to be the biggest beneficiaries.

Don’t Rule Out a Disappointment

Despite the market’s rosy forecast for consumer spending, don’t rule out a disappointment. The International Council of Shopping Centers Chain Store Sales index reported a softer increase in consumer spending. Like the Business Wire Data, the biggest drop was in apparel, furniture and department stores. Discounters, drugs and wholesale clubs on the other hand were the largest gainers. Furthermore, according to the Beige Book report released on Wednesday 10 out of the 12 districts reported slower consumer spending while the remaining 2 (Boston and NY) reported mixed results.

Labor Market Should Remain Weak

However even if retail sales were strong in May, there is an underlying fear that future releases could weaken. Recent Non Farm Payrolls and ISM employment figures had profound impact on the markets, as the rise in unemployment sent out negative signals to investors. There is a close correlation between both figures as indicated by the following chart. If this trend persists, coupled with tighter lending practices, the retail sector will be facing tough times ahead, as cash strapped consumers cut back further on their discretionary spending. In addition, the recently distributed government stimulus checks have been a big help for consumers, however the same cannot be said for retailers. Numerous sources indicate that consumers have been using the extra money to pay existing debt or putting it into their saving account for a rainy day. Consumers are becoming more conservative with their spending habits, which could potentially hurt retailers. It remains to be seen if the markets would continue to remain so upbeat about future releases.

Implications for the US Dollar

Since the market has turned very bullish dollars after Fed Chairman Ben Bernanke confirmed that interest rates will be left unchanged at their next monetary policy meeting, traders may shrug off any underlying weakness in the retail sales report. Unfortunately they understand that with inflationary pressures rampant and interest rates already at 2.00 percent, the Federal Reserve does not have much room to respond to weaker growth by cutting interest rates. Therefore as long as retail sales do not drop by more than 0.5 percent, at worst we should see mild dollar weakness and at best, a further rally in the US dollar in response to Thursday data.

Jamie Saettele is a Technical Currency Analyst for FXCM.