The catalyst for the global market sell off was primarily the acceleration of the European debt crisis, which in the last few days of last week become a classic fear driven liquidity crisis as Italian and Spanish bond yields rose sharply, to above six per cent, on concerns over their creditworthiness. Ironically from a Jamaican perspective, interest rates of above seven per cent were regarded by the international markets as the point at which interest costs become unsustainably high for both countries. The situation was compounded by the perception (in some cases reality) that European policy makers, government Ministers and parliaments were on holiday at the beach. Moreover, the European Central Bank was still stoutly resisting what markets had come to regard as inevitable, namely that it should become the lender of last resort to the banks and a market maker for European debt.

The collapse started last Thursday when America’s most widely followed stock market index, the Dow Jones Industrial Average, fell over 500 points (it was down 10.5 per cent in a week), the biggest drop since the panic in 2008. According to the New York Times, the sell off has erased US$8.1 trillion, or 14.8 per cent of world market capitalization, from global stock markets since July 24.

However, the real driver of the market correction, as evidenced by the collapse in global stock but not bond prices, is the longer term fear of a global “double dip” as international investors finally realised that their projections of US growth, and therefore the global economy, were wildly over optimistic.

S&P strips long-term US debt of triple A rating

This investor crisis of confidence was accentuated by a singularly badly timed move by Standard and Poor’s (S&P), who, on late Friday afternoon after the markets closed, stripped long-term US debt of the AAA rating it has held for 70 years.

S&P lowered the US one notch to AA+ , and reiterated a negative outlook.

Ironically US interest rates have actually fallen further since the downgrade of their credit due to the deteriorating outlook for their economy, and because the other major rating houses — Fitch and Moody’s — have so far maintained their AAA ratings. However, the latter two rating agencies also have the US on negative outlook, suggesting another downgrade is possible over the next several months. The US now has a split rating, meaning that most investors effectively treat the US as still triple A. At AA+, according to S&P, the credit rating on US long-term debt is now on par with new Zealand, and ranks below countries such as Britain, France, Australia and even tiny Isle of Man.

European banking stress was the canary in the coalmine

As occurred during the financial crisis in late 2008, the canary in the coalmine was a sharp increase in inter-bank market stress in the first half of last week, as European banks appeared to stop lending to each other. During the first half of the year, Europe’s relatively tight money policy had led to many of its banks funding themselves via a U.S. money market that was extremely liquid after the U.S. Federal Reserve’s QE2. By June, half of the investments in the U.S. money market funds were to fund European banks. These money market funds are now getting hit by redemptions accentuating the bank funding crisis in Europe in what appears to be a never ending drama. A vicious circle had emerged between debt stressed sovereigns, whose bond prices were falling, thereby reducing the capital in European banks, and making the banks themselves less able to continue to be the primary buyers of their home countries sovereign debt.

In a situation one would call better late than never, for the past two days the European Central Bank has been buying Spanish and Italian debt, pushing yields down nearly a point to just above 5 per cent after receiving commitments to IMF style austerity from Italy. At a press conference Friday, Italian Prime Minister Berlusconi and his respected Finance Minister Tremonti held hands to show their unity after their public squabbling.

The ECB can print money, so in the short run it is now being regarded as the safety “bridge” for euro-denominated debt issuance from problem countries until the European Financial Stability Fund (EFSF) is expanded at the end of September. The key problem is that the European Central Bank, by itself, is completely under-capitalized to buy Greek debt, never mind the debt of the rest of Europe. As of Tuesday evening, the European interbank market still appeared to be highly stressed, suggesting investor caution is still in order.

Federal Reserve to the rescue? Not so much

The three main US indexes plunged in the half-hour after the US Central Bank, the Federal Reserve, announced no concrete steps at their Federal Open Market Committee (FOMC) meeting yesterday, such as more quantitative easing, to foster economic growth.

However, after the initial fall, the Dow Jones industrial average was up 429.92 points, or nearly four per cent, at 11,239.77, Standard & Poor’s 500-stock index was up 53.07 points, or 4.74 per cent, at 1,172.53, the largest point gain in a day since March 2009, and the Nasdaq was up 5.29 per cent, or 124.83 points, at 2,482.52. On further reflection, it is likely the market took comfort from the Fed saying that it expected to keep rates low until mid 2013, and that they were “prepared to employ these tools as appropriate.”

The fact that three members of the FOMC dissented, preferring to maintain the pledge to keep rates low for an “extended period” suggests that there will be a high bar for additional stimulus. Either the stock market has to fall further, or asset prices, such as a continuing fall in housing.

This financial turmoil is not good for an already weak Jamaican economy, which could see negative transmission effects through tourism, remittances and bauxite (commodities have sold off sharply) as occurred in 2008. The only silver lining is that so far (outside of Europe), the international bond market has been relatively unaffected. Indeed, US ten year bond yields fell to nearly 2.2 per cent today, and emerging markets are being talked about as the new safe havens. Although that is unlikely to include highly indebted sovereigns such as Jamaica, assuming successful IMF negotiations, it may still allow scope for even lower interest rates locally. More importantly, the current dramatic fall in global oil prices, with West Texas intermediate falling below $80 per barrel, should lead to lower inflation and greater consumer purchasing power, as well as offsetting any deterioration in the balance of payments.