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Euro Drops as Consumer Spending Contracts

- Why the Federal Reserve Needs to Pause - Pound Sterling Declines as CBI Index Hits Lowest Level in 16 Years

DailyFX Fundamentals 04-29-08

By Kathy Lien, Chief Strategist of DailyFX.com

Why the Federal Reserve needs to pause

No one wants to be in the shoes of the Federal Reserve today as they begin their two day monetary policy meeting.

Fed officials face a tough decision when they weigh the risk of deteriorating growth with that of rising inflation. Unfortunately for the Fed, the problems with growth and inflation have only escalated in recent weeks.

The US economy shed jobs for three months in a row and job losses are expected to continue this month. The US economy is in a recession and it may be just a matter of time before the US central bank admits it.

As indicated by the tables in our FOMC Preview, the housing market and the labour market have deteriorated since the last Federal Reserve meeting.

The only dollar positive news has been the increased inflation pressures and mild improvement in manufacturing sector activity. However despite the rise in service and manufacturing ISM – they both remain in contractionary territory. At this point the Federal Reserve’s options are limited since they cannot raise interest rates to combat inflation.

One of their only options is to let the dollar rise. The strength of the Euro has helped the Eurozone fend off inflationary pressures while the weakness of the US dollar has only exacerbated them. To cut interest rates by 25bp and then signal that they will pause in June would be a simple gesture by the Fed that could bring significant benefits.

Traders would assume that the Fed’s rate cuts are over, at least for the time being and as result, they may send the Euro back towards 1.50 and USD/JPY back above 105. A stronger dollar will reduce some benefits for US exporters, but it could help curb inflationary pressures.

Postponing any additional easing after their anticipated quarter point rate cut on Wednesday does not mean that the Fed has put an end to their easing cycle. They are just giving the market an opportunity to absorb the 325bp of rate cuts that they have will have doled out since August and any temporary boost from tax rebates. If the economy does not respond, then they could easily pick up where they left off.

Right now, they need to buy themselves some time by forestalling further inflationary pressures. The outlook for the US economy remains weak with house prices falling by the largest amount since 2001 and consumer confidence posting its biggest three month slide since the last recession.

What is most worrisome about the April consumer confidence report is the fact that the ‘jobs are plentiful’ question saw the worst response since September 2004 while the ‘hard to get jobs’ question received the highest response since 2004.

Euro drops as consumer spending contracts

The EUR/USD has continued to sell-off as incoming economic data reveals further weakness in the Eurozone economy.

Not only did Deutsche Bank, Germany’s largest bank, report its first loss in five years, but the Bloomberg Eurozone Retail PMI index hit a record low.

Sales fell across all three of the largest euro member states with consumer spending in Italy reporting the biggest dip. Sales in Germany and France are both in contractionary levels.

Despite higher food prices, sales of food and drinks fell by the fastest rate in more than two years. This suggests that retail sales across the region will see a similar decline. Fundamentals, technicals and sentiment all support further losses in the Euro.

The one thing that could have triggered a meaningful turn in the single currency was reasons for the European Central Bank to cut interest rates. If economic data deteriorates even further, the central bank may have to seriously consider this possibility.

The futures market currently does not expect an interest rate cut until the end of this year at the earliest. Anything to suggest otherwise could cause more volatility in the Euro. German unemployment is due tomorrow and we expect the employment numbers to be Euro negative.

Sterling declines as CBI Index hits lowest level in 16 Years

Like the Euro, the Sterling has been hit by weaker consumer spending. The CBI distributive trades survey dropped to the lowest level since November 1992.

Although the Easter holiday and poor weather affected consumer spending, the primary reason why consumers are tightening their belts is the weakening housing market.

Conditions will be challenging going forward, which could force the Bank of England to cut interest rates again despite growing inflationary pressures.

This morning, BoE Governor King said that inflation will hold near their 3% target for longer than initially anticipated. These hawkish comments conflict with the sharp drop in mortgage approvals and the possibility of major layoffs in the UK in the coming months.

New Zealand and Australian Dollars Sell-Off, Canadian Dollar Holds Steady

Yesterday we said that the rallies in the New Zealand and Australian dollars were unconvincing. Unsurprisingly the moves have reversed themselves.

The biggest mover was the New Zealand dollar which dropped 1.2% against the greenback. The country’s trade surplus turned into the deficit last month, which was only the second time in the past 10 years that New Zealand reported a deficit. We had called for a weaker number in yesterday’s Daily Fundamentals, given the sharp drop in the Purchasing Managers Index.

The Australian dollar also came under selling pressure as business confidence dipped into negative territory in the first quarter.

The Canadian dollar was the only commodity currency to rally even though we think that weakness will resume in tomorrow’s GDP report. Retail sales have been weak, which points to softer GDP growth in the month of February.

Weakness seen in all Japanese Yen crosses

All of the Japanese Yen Crosses have sold off today with the biggest drop seen in GBP/JPY and NZD/JPY. Stock market traders are treading carefully ahead of the FOMC rate decision while the move in the Yen crosses confirm that some traders are lightening up on risk.