Will the Fed aggravate a recession? by Harold AGJ Davis,

 In recent months, the Federal Reserve has been signalling the impending end of their ultra-accommodative monetary policy. While that eventuality is understandable, they may have picked the wrong time.

In forecasting, it is widely understood that raw material prices act as an economic barometer because they are extremely sensitive to pressure changes in industrial activity. Ordinarily, the recent collapses in crude oil and natural gas prices would have been treated as harbingers of an economic downturn, but they have been ignored owing to the background story of “fracking”. However, it is harder to explain away the extended drops in other industrial commodities such a lumber, copper, aluminum, zinc, and tin.

Some may view sliding raw material prices as evidence of deflation as if to offer an argument that, somehow, lower prices are attributable to something else besides inadequate demand and excess supply. While price levels certainly can be influenced by liquidity, wealth creation/destruction and money supply, the raw material price declines predate any restrictive policy changes. Very simply, global economic activity may be positive, but it is far from robust. Now, the situation may take a turn for the worse.

The Fed’s tough talk has already influenced capital flows. Foreign borrowers with U.S. dollar loans could find their total cost of credit adversely effected by interest rate induced foreign exchange volatility. Not only will higher U.S. rates increase borrowing costs, but hikes enhance the relative attractiveness of the U.S. dollar. The result is a rush to replace and repay U.S. dollar denominated loans, and that means aggressive buying-in.

The U.S. Dollar Index has already soared by 25% between July 2014 and March 2015. Now, after eight months in a wide swinging trading range, the U.S. Dollar Index is threatening to breakout and run again. The first 25% appreciation of the greenback impaired American manufacturing competitiveness. If prospects for Fed tightening trigger another run, fresh dollar strength could do outright damage.

The seriousness of the current threat is visible in the capital markets. Yields on 5 year Treasuries have risen from 1.35% to 1.65% in the past week. This term coincides with corporate commercial term loan demand for plant and equipment whereas the meager move from 2.85% to 2.99% in 30 year Treasury bonds reflects the disbelief of bond portfolio managers.  Indeed, it is a common investor expectation that short term interest rates will only rise by roughly 1.0% over the next two years.

To the contrary, the experience of the last 20 years shows that short term interest rates can quickly spike by 3.0% in 1 ½ to 3 years. In this context, it seems that corporate treasurers remember history and are not prepared to bet the enterprise on a forecast. Moreover, this sort of cautious corporate thinking can sink business expectations, and retrenchment may follow. If so, slow GDP growth could slip into recession in early 2016.

Can the Fed stop this? Now that expectations for a rising rate cycle have been confirmed by Fed comments and FOMC meeting minutes, can they back down or delay without risking their credibility? If the Fed retreats, might the market interpret it as a dishonest policy move to avoid interfering in an election? Damned if they do or don’t, the period just ahead is fraught with risks.

Harold AGJ Davis is the Author and Analyst at www.prairiecropcharts.com