Most surprising thing that markets have ignored

James Sweeney | Chief Economist, Credit Suisse
Pedestrians carry shopping bags on January 14, 2015 in San Francisco, California. 
Justin Sullivan | Getty Images

Global industrial production has grown solidly since September following a stretch of weakness – roughly from April to August – linked to Japan's consumption tax hike, generally sluggish Asian growth, and a pause in Europe's economic recovery.

The most surprising thing about the stretch of growth since September is how thoroughly it has been ignored by financial markets. We think the sharp fall in oil prices led the market to believe that growth "must be collapsing" even though a rigorous review of tradable sector data reveals no such thing. (Tweet this)

Indeed, the market "noticed" the growing deflation risks in late 2014, rather than the rebounding world economy. In our conversations with investors we saw an almost myopic linking of every headline to heightened deflation risks.

Central banks cutting? It must mean deflation is coming. Oil falling? It must mean growth is collapsing and deflation is on the way. Switzerland revalues? A further shock to aggregate demand in Europe: deflation.

Source: Credit Suisse, Google

Although falling oil prices have sent headline inflation toward negative territory in many parts of the world for the short term, this is a classic example of a non-persistent move in inflation. In other words, the type that policymakers are meant to ignore inmost cases.

Falling oil prices, reduced long-term interest rates, and easier global policy at a time of accelerating global growth is a mix of factors that should help to cut spare capacity and boost inflation over time – not diminish it. The latest version of the deflation view is that U.S. dollar strength will cause U.S. import prices to collapse, lead to very low inflation, and prevent the Fed from lifting rates.

But the U.S. is more closed than other major economies. History suggests goods price deflation can easily be offset by services inflation. And while the dollar may wreak havoc on corporate earnings, we are not convinced that U.S. firms' hiring and domestic investment plans are closely linked to the dollar value of their overseas earnings. We regard the slowdown in the energy sector and its potential to push the ISM manufacturing index lower in the near term as a bigger threat to markets and to the possibility of a Fed hike in September or (in our view) June.

Read MoreIf Fed loses 'patience,' that could mean June rate hike

Meanwhile, in Europe, the very strong recovery in retail sales in the past six months is a reason for confidence that a descent into persistent deflation is not so likely. Couple that with signs of life in credit growth, a much weaker currency, extremely low real interest rates, and a rising equity market, and the recent deflation fears begin to look paranoid.

However, a caveat: global industrial production (IP) growth is set to slow in the months ahead, with only the euro area likely to buck the trend of falling momentum between January and the summer. Does this mean growth risks will now limit the potential for riskappetite and yields to rise?

Maybe not. Deflation fears have been so strong that global IP growth has been negatively correlated with risk appetite and interest rates since the end of last summer. This is not normally the case, but it's not unprecedented either. A six month period of a sharply negative correlation historically has occurred every few years. In between,correlations tend to go strongly positive. Since 2010, for example, the correlation on monthly U.S. 10-year yield and global IP momentum data has been 0.68, despite the -0.73 6-month correlation in January!

In our view risk appetite is being driven by rebounding confidence in European growth, so slipping global growth may not be a big deal as long as a severe slump does not occur. We do not expect sharply weaker growth or a financial stability event in the months ahead, but either could block a June Fed hike. The correlation between global growth and markets should eventually reassert itself, but for now markets must unprice deflation mania.

James Sweeney is a Managing Director of Credit Suisse in the Investment Banking division, based in New York. He is the Chief Economist for the Investment Bank and Co-Head of Global Economics and Fixed Income Strategy. He heads both the US Economics team and the Global Strategy and Economics team. James joined Credit Suisse in 2000, having previously worked as a political speechwriter. James holds an MSc in economics from the London School of Economics and a BS magna cum laude from Florida State University.