The U.S. dollar index (DXY) pulled back 0.38% to close at 99.82 on Tuesday, after the Institute for Supply Management (ISM) reported that its manufacturing index was 48.6 in November, its lowest level since June 2009, a decrease of 1.5 percentage points from the October reading of 50.1. A reading below 50 indicates contraction in the manufacturing sector. The index missed the expected 50.5 reading of economists surveyed by Reuters. 

The weak ISM manufacturing index data came on the heels of a sharp drop in MNI's Chicago purchasing manager's index (PMI) on Monday, an indicator of business manufacturing and overall business activity in the Midwestern U.S., which plunged to 48.7 in November from 56.2 in October, missing Bloomberg economists’ estimate of 54. The strong dollar has reduced overseas demand for U.S. manufactured products. Some analysts, including Peter Boockvar, chief market analyst at The Lindsey Group, told CNBC that "We're in manufacturing recession.”

Ironically, the DXY has risen over 6% since mid-October, after the U.S. Federal Reserve released its Beige Book indicating that the U.S. economy continued modest expansion at the end of the third-quarter, as the strong dollar continues to hurt certain sectors of the U.S. economy including manufacturing, energy and tourism. At that time, the Federal Reserve said industrial production slipped 0.2% in September after falling 0.1% in August. Manufacturing output, the biggest component of the industrial production index, fell by 0.1% in September, following a 0.4% decline in the prior month.

It should have become obvious to the Fed by then that U.S. manufacturing was in trouble. Instead, some Federal Reserve officials began to argue their cases for an early rate hike. The Fed committee, including Fed Chair Janet Yellen, is now convinced that they are ready to raise rates before the end of the year, despite the mixed bag of U.S. economic data of late, and an industrial sector that is already heading into a technical recession.

The federal funds futures, traded on the Chicago Mercantile Exchange and commonly used to estimate the market’s views on the likelihood of changes in U.S. monetary policy, jumped to 24.8% from yesterday’s quote at 22.5% odds for a quarter-point rate hike at the Fed’s FOMC meeting on December 15-16 while the odds for a half-point rate hike dropped 2.3 percentage points to 75.2% from yesterday’s quote at 77.5%, according to data from the CME Group as of December 1. 

The bond market sees it differently than the Fed though, as it is betting against the possibility of the Federal Reserve interest rate liftoff in December. The yield spread between the 10-year and 2-year Treasury Notes has been falling since July 10, at 1.77 percentage points, and just broke the March 24 support of 1.30 percentage points. The 10-year and 2-Year yield spread tumbled 3.74% on Tuesday, to print at 1.236 percentage points. The next support level is at 1.19 percentage points, or the February 2 low. 

Falling spreads may indicate worsening economic conditions in the future, resulting in a flattening yield curve. A very low or negative spread could signal an upcoming recession.

The currency markets are apparently more worried about the Fed rate hike at the December FOMC meeting and less about the weakening U.S. economy, as seen by the flattening yield curve. Technically, the DXY is moving in a bearish ascending wedge (ASC/W) chart pattern, but unable to break out the 100 level trendline resistance. There is a possibility that the index could pull back to the 98.14 and 97.61 levels, as the dollar is now overbought. A near-term risks are the Governing Council of the European Central Bank (ECB) meeting in Frankfurt on December 3 and the U.S. non-farm payrolls report on December 4. 

The ECB could announce the expansion and extension of its 1.1 trillion euro bond-buying program. The move could bump up the U.S. dollar against the euro. For the U.S. non-farm payrolls report due on Friday, 8:30 AM ET, the market is expecting a 200K jobs gain, with the unemployment rate unchanged at 5.0%. A bad print on the jobs report could trigger a bond rally and flattening of the yield curve.