The world of financial markets doesn’t get any more frenetic than this. In the last few weeks, we have seen significant turmoil across a wide range of markets with sharp daily movements in the price of bonds, equities, foreign exchange and commodities, including oil and gold.

The trigger to this recent bout of market jitters was the bail-out of Bear Stearns, the fifth-largest investment bank in the USA. The rescue of this latest victim of the subprime crisis in the US housing market and the subsequent credit crunch raises some really big questions; none more so than how close is the US financial system to a complete meltdown?

What if the drugs don’t work ?

Until now, it was possible to argue that although the US economy looked fragile, the US authorities had the right medicine to cure the patient. During the dark days of 2001, for example, when US share prices went into free fall (remember the end of the dotcom boom?) as the economy moved to recession, aggressive interest rate cuts managed to fix what was broken; the real economy improved, the US dollar rallied and confidence returned to the world’s financial markets.

That optimism has now gone, to be replaced by growing pessimism. US interest rates have already been slashed to 2.25 per cent from a peak of 5.25 per cent, a USD200 billion package of tax cuts is on the way and the US authorities have injected much needed liquidity into the money markets. Despite all this, there has been no major sign of improvement in the US economy. In other words, the Fed’s latest rescue efforts have fallen on deaf ears.

The US dollar’s value is plunging against virtually everything, with the euro now pushing above USD1.55 (compared with USD1.33 twelve months ago). International investors seeking to divest themselves of exposures to the US have helped push up commodity prices with oil prices reaching a new high of USD110 per barrel and gold hitting USD1,000 an ounce in March. We’re not an island It is becoming apparent that there may not be a quick fix solution to this lack of confidence across world financial markets if the problems in the USA are not going to go away as easily as they did in the past.

Indeed, the UK is being tarred with the same brush as America, being seen as vulnerable on account of a strikingly similar long bull run in the housing market and an even higher level of household indebtedness. On the currency markets, Sterling has also fared badly, falling to a new all-time low of under EUR1.27 by mid-March, and is the only major currency not to record sharp gains against the US dollar during recent weeks.

Similarly, amid wild day-to-day fluctuations, the FTSE-100 share index fell by almost a tenth to 5500 in the four weeks to 25 March. Perhaps even more worrying, is the effect of all this uncertainty on the UK banking system. The usual trust and confidence that exists among banks and other financial institutions has been temporarily undermined. Banks that would normally lend money to each other in the money markets are now taking a more cautious approach, hoarding their liquidity.

This can be seen most readily in the rise of short-term interest rates. In the UK, the benchmark interest rate in these markets is three-month LIBOR (London interbank offered rate). In normal circumstances, it tracks Bank of England’s base rate closely, but in recent weeks, the gap has widened to almost 0.75 per cent because the supply of available funds has dried up.

For the rest of this important story, read the full HSBC Global Market update (pdf format)