Rampant fear of a US recession is behind the turmoil on the international stock markets, writes Arthur Beesley 

Hard times. Stock markets around the world endured exceptional volatility this week as investors lost their nerve - and capital - in the face of a likely US recession. While shares regained ground yesterday, a €5 billion fraud at French bank Société Générale shows that an already-jittery financial system remains prone to big shocks.

"It's probably the worst ever January in terms of market movements. This has been an appalling opening month of the year. A negative January statistically has proven to lead to a negative year," says Gary McCarthy, managing director in Dublin of stockbrokers Collins Stewart.

The meltdown was tempered to an extent by a "once-in-a-generation" emergency interest rate cut by Ben Bernanke, chairman of the US Federal Reserve. But the refusal of European Central Bank (ECB) president Jean-Claude Trichet to follow suit was enough to keep markets on very rough seas.

The immediate catalyst for the sell-off was rampant fear of recession in the US, the world's largest economy and a bellwether for business conditions around the globe. Weak data from US factories, retailers and the housing market added to the sense of foreboding brought on by the subprime credit crisis, which has brought multibillion-dollar losses to some of Wall Street's mightiest investment banks.

To cap all that, an ominous new threat to the stability of the international financial system emerged in the form of questions about the credit-worthiness of specialist insurers who guarantee thousands of billions of dollars in bond repayments.

Bernanke clearly signalled a fortnight ago that he stood ready to cut rates aggressively to ward off inflation. But while supporting US president George W Bush in his proposal for a $150 billion (€102 billion) fiscal package to stimulate the US economy, he insisted late last week that he was "not currently forecasting recession".

Was the Bush plan enough? No, roared the markets. With US exchanges closed on Monday for the Martin Luther King holiday, European stocks lost €240 billion of their value in the worst one-day decline since the attacks on the US on September 11th, 2001. Conditions in Asia and elsewhere were no better, indicating that investors believe international economies will not be immune to difficulties in the US.

Cue Bernanke's drastic intervention on Monday night, when the Fed cut its benchmark interest rate by three-quarters of a percentage point after a video conference meeting of central bankers. The manoeuvre, which was the largest single rate cut since 1984, and was signed off outside the Fed's schedule of regular meetings, added credibility to fears about the prospects for the US economy.

While Bernanke is interventionist by nature, analysts reported that he only recently converted to the idea that the balance of risks in the US economy now tilts more strongly against growth than for inflation.

Still, the Fed's extraordinary action raised questions as to whether it knew something more than the markets at large about trouble down the line, or whether it was merely catching up with the view that recession is unavoidable.

Richard Reid, a director of the economic and market analysis unit at Citigroup in London, says the rate cut was swifter and deeper than expected.

"I think when markets get this kind of experience, there's always a tendency to think that it knows more than we do.

"We've had the perception for a number of months that the Fed has taken the view that an easier policy mistake to correct is that of moving too quickly, too soon rather than waiting too long and finding out that you've got yourself in a much bigger hole."

No longer is it argued that the US economy would be unhurt by the credit crunch on Wall Street. Investors who were encouraged by good earnings growth in non-financial sectors and booming emerging markets have changed their minds.

The sense now is that the crunch is not going to be a short-lived affair, with a consequent reduction in the availability of credit to the business world generally.

With big writedowns weakening balance sheets of international banks, US lenders are already making it harder and more expensive for some small and mid-size business groups to borrow money. In addition, an ECB survey last week pointed to reduced demand for loans from euro zone business groups and a tightening in credit standards.

If this supports the view that negative fallout from the US is already damaging the European economy, Trichet's reluctance before the European Parliament on Wednesday to give ground on European interest rates fanned the flames of a further sell-off of shares. Still, markets believe the ECB will cut rates later this year to insulate euro zone economies from difficulties in the US.

European markets closed 5.4 per cent stronger last night, after losing more than 3 per cent on Wednesday. In the US, shares rallied on Tuesday after Bernanke's move and made more ground on Wednesday after it emerged that the New York state insurance regulator was mulling a rescue plan to prop up bond insurers. They went upwards early yesterday after weekly unemployment data suggested the US job market is holding up.

But extreme volatility remains. The private-equity owners of Tommy Hilfiger moved yesterday to postpone for an indefinite period a $2 billion flotation of the fashion group. Shares in Apple Computer lost 12 per cent on Wednesday after weak sales of its iPod music player, proving investors remain nervous of any downgrading of expectations.

"Nobody is quite sure if the macroeconomy, still growing at a decent pace outside of the US, or the financial crisis has the upper hand. Therefore the uncertainty is playing out in the markets," says Karen Olmey, chief European equities strategist for Merrill Lynch in London.

"If we're not thrown into a early 1990s-like recession or something worse, the market is a buy. That's my view."

In terms of optimism, however, it is clear that the markets are running on empty this week. The big question now is when sentiment might turn.

Quite what the catalyst will be remains to be seen. "Equities still have to get over the 'valley of fear' on things like earnings and write-offs in the banking sector before you can really start to enjoy the lower interest rates," says Reid of Citigroup.