Investors were in celebratory mood yesterday. Let's hope their celebrations aren't premature. Few seemed bothered yesterday. Encouraged by the latest round of central bank interest rate cuts and convinced that after Monday's falls stock markets were priced for an Armageddon that wasn't going to happen, investors have plunged joyously back into the market. The effects have been suitably dramatic. At yesterday's close, the Hang Seng Index stood at 14,330 points. That's an astounding 34 per cent above Monday's intraday low (see the first chart below). To put that gain in perspective, it is as much as the market returned in the whole of 2006. Only in four years out of the last 15 has the Hang Seng bettered that performance. It wasn't just the Hang Seng. By yesterday's close, the H-share index had climbed 41 per cent above Monday's low. Mainland markets also rose, as did commodity prices and Asia's minor currencies - all severely battered in recent weeks. Three factors combined yesterday to help convince investors that the rally which began on Tuesday may actually have legs. First, there was the conviction that after Monday's falls, Hong Kong-listed stocks were looking ludicrously cheap at just a whisker over their book value. Then there was the latest round of central bank interest rate cuts, initiated by the People's Bank of China, which cut its key rates by 0.27 of a percentage point on Wednesday evening, the third reduction since mid-September. The US Federal Reserve followed, cutting its benchmark rate to just 1 per cent, which also triggered cuts in Taiwan and Hong Kong. With the Hong Kong Monetary Authority's base rate now down to 1.5 per cent, and following repeated liquidity injections, overnight interbank rates in Hong Kong have fallen to just 0.6 per cent. Although rates for longer periods remain stubbornly high, preventing local banks from cutting their own lending rates, normality is slowly returning to Hong Kong's money markets (see the second chart). And finally, the Fed's extension of its temporary swap facility to central banks in Korea and Singapore helped end the scramble for US dollars and reduced the chance that regional companies might default on their US dollar debts because of their inability to secure the funds to service them. Yet despite the good news of the last few days, we are not out of the woods yet. With economists warning that the world is heading into a deep and protracted recession, fears are growing that demand may contract so much that developed economies will not be able to avoid sliding into central bankers' worst nightmare of all: deflation. It was only a few months ago that we were more worried about inflation. But in some ways deflation is a worse scourge. Whereas inflation hurts ordinary consumers and savers, deflation is especially hard on companies. When prices fall, companies have to sell greater quantities of goods to service their debts and make profits. But in a deflationary environment, consumers postpone their purchases, making sales harder to generate. The result is shrinking profits and rising defaults. Worse, while central banks can battle inflation by raising interest rates, they have few weapons with which to fight falling prices. Interest rates can only be cut to zero. But with deflation, even zero can be a punitively high interest rate in real terms. In that situation, all central banks can do is simply print money in vast quantities. However, even that high-risk strategy may not succeed, as Japan proved in the early years of this decade. It is a scenario US Federal Reserve chairman Ben Bernanke is determined to avoid. But with US interest rates already down to 1 per cent, he is running out of ammunition. If he loses the battle, investor sentiment could come back down to earth with a nasty bump.