Asking the question are the markets overheating may seem a bit premature for the first day of the New Year but today's strong global PMI data may make it difficult for policymakers to ignore the surge in asset prices and commodity markets. Manufacturing PMI's were reported higher in China, Europe and the US and equities and commodity prices surged in the first trading day of 2010. China reported that manufacturing PMI rose to its best level since April 2004. EU Manufacturing PMI is at a 21 month high and UK manufacturing PMI was reported at two year high. US manufacturing ISM came in above expectation confirming expansion in the manufacturing sector of the US economy with a reading well above 50.

China's PMI report shows that manufacturers raised their prices at the fastest rate in 17 months in December. The prices paid index of the US ISM rose 6.5 percentage points to 61.5. Based on today's PMI report from China and the US the global economy is expanding and inflationary pressures may be accelerating. Commodity prices surged along with equity markets today. Demand for commodities was attributed to report that China may use some of its FX reserves to buy crude oil and commodities and by fresh carry trades as interest rates remain at record lows. Gold traded over $25 higher, crude oil prices topped $80 a barrel and copper prices traded at a 16 month high in Monday's trade. This type of price action may generate concern that accommodative central bank monetary policy and expansionary fiscal policies have increased the risk of inflation and creating a new bubble in asset markets.

In a speech before the American Economic Association last week, Fed Chairman Bernanke rejected claims that the Feds policy of keeping rates low contributed to the housing bubble and he suggests that stronger regulation is needed to prevent a new financial crisis. He went on to say that raising interest rates is an option if new bubbles form and other approaches aren't working. At the end of 2009 investors were beginning to look for a shift to a tightening of Fed policy as the global economy recovers. Bernanke's comments suggest that the Fed may not be quick to act on rate policy despite rising markets. If the Fed is seen willing to delay action on interest rates another asset market bubble could emerge. A few more trading sessions like today's where commodity prices and equities surge may have Fed officials asking the question are markets overheating. The answer to this question depends on whether the recent improvement in economic data is merely a blip or the continuation of a more sustained recovery.

Today's surge in equity markets and commodities may cloud the debate about the risks to the US and global economy when stimulus is withdrawn and the Fed begins raising interest rates. Economist Paul Krugman wrote an OP-ED piece in today's New York Times titled "That 1937 Feeling". According to the article Krugman expects the next US employment report and GDP figures to show solid growth and that calls for withdrawal stimulus will grow louder. He however believes that the improving data is a blip and that if the Fed and Congress do not realize that the job fighting the economic downturn isn't finished 2010 which begins as year of false economic hope will end in grief. Krugman discusses the risk that the Fed and governments may be repeating the mistakes made in 1937. During this timeframe policymakers prematurely tightened policy and began to withdraw stimulus concluding that the depression had ended. Krugman warns that the recent improvement in growth and employment may not be sustainable without consumer spending and long-term investment. If central banks withdraw stimulus to soon because of the perception that growth is sustainable, they may be repeating the mistake of 1937. This would increase the risk that economic growth will turn weaker midyear. Krugman says it is up to Washington to ensure that 1937 does not happen all over again but he says policy makers are already repeating the mistakes of 1937. Krugman sees the need for additional stimulus, not a tightening of liquidity conditions by governments or the Fed. If Krugman is correct rising equity and commodity markets may mask underlying weakness of the economy.

If today's price action in commodities and equities gains momentum it will be difficult for the Fed  and Chinese officials to ignore  potential risk of inflation that may be  a result or aggressive fiscal and monetary policy actions taken to combat the global recession. This type of price action could encourage the Fed and Chinese officials to withdraw stimulus earlier. An early withdrawal stimulus would heighten the risk that the US recovery runs out of steam in mid-2010. Today's price action in asset markets suggest the inverse correlation to USD price direction and risk appetite has re-emerged. Investors should be careful not to read too much into one-day price action. Friday's release of US unemployment will be a critical test of whether USD correlation to risk appetite is sustainable. Some analysts expect the nfp to show a positive reading for the first time in 23 months. A positive reading on US nonfarm payrolls could shift focus to improving US economic fundamentals, encourage Fed rate hike speculation and support the USD. The re- emergence of Fed rate hike speculation may dampen risk appetite.

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