Let’s not get carried away here. While all the good news lately has been wonderful, there’s always a “but…” attached. For example, the positive GDP for March was good, but it was helped by a collapse in imports and by population growth; and yesterday’s smaller than expected drop in employment was great, but there was a big switch from full time to part time (hours are being cut).

Money markets are now saying the next move in official interest rates will be up, possibly even later this year. Bank bill futures are pricing in a small hike this year and 75 basis points in the first half of 2010.

If we’ve learned anything these past two years, it’s that anything is possible – but rising inflation and rate hikes in 2009/10? It’s cold shower time.

Australia’s business sector is in recession, despite the recent improvement in business confidence. Orders are falling and sales are very weak. Yesterday’s labour force data confirmed that businesses are trying hard to keep staff by reducing shifts and hours but there remains a lot of excess capacity.

Housing and construction is not in recession because of the first homebuyers’ grant, government building works and immigration, all of which are coming to an end.

And although we are extremely lucky to be a part of China’s orbit rather than America’s, this week’s trade figures out of China were dreadful. The pace of decline of exports worsened from 22.6 per cent to 26.4 per cent and more importantly imports also weakened, falling at an annual rate of 25.2 per cent.

Fixed investment in China is rising (up 32.9 per cent) because of massive government spending, but at some point soon Chinese consumers must take over.

Despite the rise in Australian GDP in the March quarter, national income (that is, real gross domestic income) in the quarter fell 1.4 per cent, and we know it’s going to fall some more because iron ore prices are being cut 33 per cent and BHP Billiton said coking coal prices will come down by 58 per cent.

Rising national income, largely from booming export prices, has been the key driver of Australia’s economic success, flowing through to business investment and government revenue.

A big decline in income is unavoidable this year no matter what happens in China. If there is a problem in China, either because its economy struggles or because there is a souring of trade relations over the Chinalco/Rio deal (very unlikely – as will be explained today’s KGB Interrogation a bit later this morning), then the terms of trade and national income will deteriorate even further.

The debate over inflation is, in a sense, quite separate. Hamish Douglass, the chairman of Magellan Asset Management, made the point at a panel discussion I chaired yesterday that the arguments both ways on inflation are so strong that it is very difficult to pick.

On the one hand there is a massive monetary and fiscal expansion taking place around the world, but on the other hand there is massive overcapacity and threat of deflation (in China prices are actually falling).

Bond yields are rising because of supply concerns, or rather because governments are so desperate to raise debt to fund their fiscal programs that the market is screwing them.

Douglass reckons that for that reason alone, not necessarily inflation, long term interest rates are heading significantly higher still.

It all gets back, in the end, to debt.

The big increase in new government debt will have to be raised and serviced, leading already to higher bond rates and eventually to higher taxes.

Household debt in the western world is now being retrenched and most consumers are in saving mode (less so in Australia because of the resilient property market).

Bank and corporate debt is being replaced by equity at a furious rate. The growth in supply of equity and rising bond yields will suppress equity returns.

But apart from that, everything’s fine.