Rate rise, USD strength and recession

Head of Global Macro Investor and ex Goldman Sachs Hedge Fund Manager, Raoul Pal has a reputation for making some pretty good calls of late.  At the end of last year he picked the USD to rally strongly in 2015 (as it has done hitting a 12 year high), the price of oil would fall to $40 (as it has done), and that the US ISM Manufacturing index would fall below 50 in late 2015 (as it did last week printing 48.6).  Such indices show growth above 50 and below 50 represents contraction.  48.6 is the lowest reading since the GFC and is in large part due to the rising USD making exports uncompetitive together with faltering Emerging Markets (EMs) not buying as much off the US.  Pal points out the close correlation between the US economy as a whole and the ISM Manufacturing Index.  He believes at current levels there is a 65% chance of a recession in the US and if it drops to 47 that jumps to an 85% chance.  The graph below illustrates the correlation.

He said "The economic situation is deteriorating fast. And meanwhile the Fed seems to want to raise interest rates into that, which I think is a bit of a policy mistake and I think the market is getting more and more concerned from not understanding why they're doing it,"

As mentioned this is in part due to the USD and EM’s.  Topically, the Bank for International Settlements (BIS – the central bank of central banks) just expressed grave concerns last week in a report highlighting the deterioration in EM’s around the world and particularly the effect of the strengthening USD (which a rate rise would almost certainly see rise further).  They said:

“The financial vulnerabilities in EMEs have not gone away….The stock of dollar-denominated debt, which has roughly doubled since early 2009 to over $3 trillion, is still there [and] in fact, its value in domestic currency terms has grown in line with the US dollar’s appreciation, weighing on financial conditions and weakening balance sheets.”

Again this highlights the dilemma of the US Fed.  Raising rates has potentially dire domestic and global consequences in terms of the USD strength versus exacerbating the situation by perpetuating it.  Good luck Janet.