Severe stress in global markets has nerve-wracked investors fearful that one big shock could jam the gears of the financial system -- much like the crisis days of 1998.
"People feel like gasoline has been dumped on the floor and it wouldn't take much to ignite it," said James Glassman, senior US economist at JP Morgan Chase.
Plunging stocks and multibillion-dollar bankruptcies the past month have investors assessing the widespread damage to banks and insurers. If more scandals or failures come to light further straining capital markets, it could force central banks to jump to the rescue, pumping money into the system through lower interest rates.
Fear is starting to hurt economies as well. The financial market squeeze in both the US and Europe is depriving businesses of crucial capital and sharply increasing their cost of borrowing at a time when global growth, led by the US$10 trillion US economy, appears to be losing steam.
"The Fed has to get concerned about the capital markets effectively tightening for the Fed at a time when it wants policy to remain accommodative," said Brad Stone, chief US market strategist at Barclays Capital.
"The Fed may need to lean against that. Some weeks ago that looked like a very low risk. Now it's definitely a real risk," he said.
Interest rates charged on high-quality corporate debt right now stand at near-record levels -- 2.2 percentage points above risk-free Treasuries, up more than half a percentage point since early June.
Investors, scared they cannot trust corporate balance sheets, have proven reluctant to lend money. Corporate bond issuance by investment grade companies sank in July to US$22 billion, down 63 percent from its January to June average. Last week investment grade debt suffered its worst week since at least 1997, and junk bonds are set for their worst year ever.
Funding through the short-term commercial paper market also has become very difficult, with total outstanding issuance for nonfinancial and financial firms falling a hefty US$93 billion this year. Banks have turned skittish about lending. Initial public offerings have dried up.
"The way the events are unfolding right now for the near term, dealing with these many financial constraints is going to impinge and impinge and impinge on economic activity," said prominent Wall Street economist Henry Kauffman, who has argued the Fed should cut interest rates.
Swap spreads -- a measure of banking sector risk that signaled the systemic distress in 1998 -- popped out last week on the credit anxiety about JP Morgan before stabilizing. Investors are even raising risk premiums on assets usually considered very safe like mortgage-backed securities.
With markets so stretched, harried traders are looking anxiously for the one trigger that could set off an explosion.
"The markets continue to scan for a `smoking gun' to justify some emergency policy response," said Michael Wallace, an economist at Standard & Poor's MMS.
Rattled markets showed their heightened state of anxiety on Friday when rumors of an emergency central bank meeting in Europe to help a failing bank or insurance company swept through trading desks, sparking selling of stocks and powering gains in safe-haven short-term Treasuries.
Banking trouble fears hit a fever pitch on July 24 when rumors spread of liquidity problems at JP Morgan Chase -- the largest US bank -- and Citigroup after congressional revelations of their dealings with failed energy trader Enron Corp. The impact across credit markets was harsh and swift.
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