Stock markets have shown clear signs of irrational exuberance in recent weeks, on evidence that the US and global economy is exhibiting “green shoots” of impending recovery. Since, while I have said several times that the economy appears to be approaching a near-term bottom, I don’t expect recovery to impend any time soon, I thought it worth examining these “green shoots” to determine which were most likely to wilt first.

Let’s start with one that looks pretty robust. Global trade, particularly in the Asian supply chain to the United States, dropped a frightening amount in the first couple of months of 2009. This was very worrying; it appeared possible that we would see a repeat of the Great Depression’s trade madness, when trade declined by 65% in four years. That reduced a lot of the “comparative advantage” efficiencies in the world economy, whereby goods are manufactured in those countries with the best relative costs – thus a repeat of it would have had truly dire implications for global economic prospects, effectively reversing globalization in one bound.

There was however another possibility, which was that US consumption declines caused an inventory backup in the Asian supply chain which, combined with the inevitable difficulties for exporters getting financing, sharply reduced trade for a short period. More recent figures have shown a considerable trade recovery, indicating this to be the most likely explanation. Thus, while trade will not recover completely since the US savings rate has increased and consumption declined, this partial trade recovery is indeed a genuine “green shoot” that will not reverse.

A second “green shoot” that looks likely to persist, although not entirely, is the increased solidity of the US banking system. Back in February, Treasury Secretary Tim Geithner was wailing that the US banking system needed another $1.5 trillion to fix it. Given the relatively robust state of most regional banks, that always looked unlikely, and I said so at the time. Now the “stress tests” have found that a mere $80 billion of new capital, most of it raised freely in the market, will fix the problem. Geithner’s panic in February, which may have been assumed in order to generate support for the bloated and damaging “stimulus plan,” has thus proved wide of the mark.

Having said that, this “green shoot” is by no means assured of growing into a healthy tree. Unemployment figures released Friday showed a continued increase in the unemployment rate more rapid than in past post-war recessions – up by 4.5% in only 2 years, faster than in 1979-82, when it took 3½ years to rise 5.2%. The Treasury’s “stress test” assumptions were based on data from past recessions; if unemployment continues to rise at a rate with no past parallel since the Great Depression, or continues to rise to a level above the postwar record (10.8% in November/December 1982) then we will be economically “off the map” and it is entirely possible that bank loss rates will rise far above the stress test predictions.

After all, there can be no certainty that the relationship between unemployment and either credit card or mortgage losses is linear; it is possible that there is a “tipping point” as unemployment continues to rise, at which foreclosures or credit card losses increase to such a point that they become self-reinforcing, escalating uncontrollably with only a modest further deterioration in economic conditions.

The principal cold gale causing green shoots to wither will probably be the inexorable rise in long-term interest rates. This has already begun; the 10-year Treasury yield is up from its low of 2.07% in December to around 3.3% today. However, the enormous Treasury financing requirement and the increasing visibility of inflationary signals will cause it go much further. In the 1990s, when average inflation was 2.9%, the same level as the recently announced first quarter GDP deflator, and the federal budget deficit averaged a mere 2.3% of GDP, the 10-year Treasury yield averaged 6.67%. That level may seem very high currently, but in fact is likely to be passed fairly rapidly, on the way to Treasury bond yields of 10% or more as deficits and inflation provide a howling adverse gale for the T-bond market. The rise in interest rates will be prolonged and initially quite slow, but we can probably expect 10-year Treasuries to yield more than 6% a year from now.

If rising interest rates are the gale causing green shoots to wither, inflation will be the frost causing them to die. Fed chairman Ben Bernanke has enjoyed a period in the public eye, even before his January 2006 ascension as Fed Chairman, largely punctuated by self-delusion on an extraordinary scale. It began with his discovery of a hitherto undetected dire deflationary threat in 2002, continued with his announcement of the “Great Moderation” in February 2004, just as his lax monetary policy was sending housing policies into orbit, continued with his accusation that evil Asian savers had caused the 2007-08 explosion in commodity prices and has now settled into an indelible conviction that, however “unorthodox” and Weimarite his monetary policies may be, inflation is far less of a danger than deflation.

It will be a race between soaring interest rates and grimly rising inflation to kill the green shoots of recovery and plunge the US economy into renewed downturn. Both factors will reinforce each other as buyers of Treasury bonds, appalled by the price declines in their holdings, will come to realize that inflation as well as soaring interest rates has made long-term Treasuries the ultimate sucker’s bet. Zhou Xiaochuan, Governor of the People’s Bank of China will no doubt be especially withering in his condemnation, discovering a hitherto little-known treatise on sound monetary policy in his copy of the Thoughts of Mao Zedong.

The housing market and its corollaries the housing finance market and the construction market will recover or wilt further depending on which of interest rate rises and inflation proves predominant. Here my crystal ball is a little cloudy. House prices are now around their long term average in terms of median income, but on the other hand there is a huge overhang of unsold housing inventory and foreclosures or potential foreclosures which would normally depress prices further.

Nevertheless, very rapid inflation without a concomitant rise in interest rates might cause the housing market to find its feet quickly. Had Bernanke been allowed to wreak his inflationary-producing magic unaccompanied by the deficit-producing efforts of his partner in Congressional obfuscation Geithner that might have happened. However in the short term Geithner’s operations pushing up the federal deficit and interest rates should win out over Bernanke’s attempts to push up inflation by lowering them. In that event, further green shoot wilting and chaos in the housing market is likely, producing knock-on negative effects on construction, mortgage finance and the US banking system.

With higher interest rates, higher inflation, a wobbling housing market and a wobbling banking system the stock market’s recent exuberance is most unlikely to continue for long. Currently, particularly in the financial sector, the riskiest and most damaged stocks are showing greatest strength, which is always a worrying sign. At some point, investors will note that the old problems haven’t fully gone away, while new problems have appeared. Then a rapid stock market decline below the March lows will probably occur, although there will be heavy buying at March’s levels by investors who have noticed that in March, stocks at those levels proved to be bargains. This time around, the bargains will be false ones, as further earnings damage is in store through the rising cost of debt in an overleveraged economy.

Consumer spending has shown signs of strength recently, as consumer confidence has risen from its low and retail sales have edged upwards. However, the consumer savings rate, at around 4-5% of disposable income, is still too low to balance the US economic system, while consumers’ asset holdings are depleted far below their levels of a couple of years ago. Hence consumer savings will rise further, probably as interest rates firm, which will in turn depress retail sales and consumer-oriented activity generally. The green shoot of consumer confidence will survive only until inflation is seen to have regained a firm grip on the US economy and the stock market has relapsed into its currently natural bearish state.

On the corporate side, the Institute of Supply Management indices for April rebounded somewhat, suggesting that recession is drawing to an end. Inventories also have begun to rebound after their exceptional weakness in the first quarter. Like consumer confidence, the modest impending rebound in production may survive for some months, until it becomes clear that higher interest rates must be factored into all cost calculations and that consumer spending is not about to revert to its robust recent trend. Nevertheless, the US corporate sector will be buoyed by an improving trade position, and will be distinctly stronger than the consumer sector. Capital spending, which has been weak since the tech bubble burst in 2000, is likely to remain so as capital costs rise.

The productivity miracle of the late 1990s was always a mirage, caused partly by record levels of capital spending and partly by statistical jiggery-pokery in price index figures. Going forward, with capital spending low and inflation rampant, productivity growth is likely to be exceptionally low, as it was in the 1970s. This will speed the economic transition from a US-dominated world economy to the new domination by east Asia. On the other hand, it might slow the otherwise inevitable decline in US living standards, as labor-saving technologies prove unattractive capital investments, while outsourcing falls victim to protectionism, expensive emerging market capital costs and slower trade growth.

Finally, back to unemployment, which on current figures seems sure to exceed 10%, and may well pass 1982’s record of 10.8%. Should it move significantly past previous post-war records into new territory, the effect on consumer costs and bank loan portfolios will be literally un-calculable, as it will have moved beyond the data on which previous regressions have been based. Beyond deficits/interest rates and inflation, this is the third potential adverse “climate” factor that could cause “green shoots” to wither for several years to come. For this reason, unemployment data should be watched closely; if the unemployment rate steams through 10% in the next few months with some apparent momentum behind it, watch out.

Economically, it is currently spring with “green shoots” apparently indicating recovery, burgeoning in the most unexpected places. The economic climate, however, is that of early February rather than mid-April. True recovery is nowhere near imminent, and economic conditions should get considerably worse before it arrives.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)