Fear is back, stalking financial markets less than a day after the US Federal Reserve cut interest rates to take pressure off financial stocks and the economy. Is this John Howard’s last hope for avoiding a damaging interest rate rise next week, and bringing him back into the election picture?

So rapid was the switch in sentiment that trading curbs were maintained for most of the day on Wall Street to prevent share prices from plunging. As it was the major indices fell by more than 2% with the Dow off a massive 362 points. The Australian market was down by just under 2% at the opening, or around 132 points.

A sharp slump in financial shares, led by the banks and Citigroup, plus renewed concerns about the US economy and a surprise earnings hiccup for Exxon, the world’s biggest oil group, combined to pressure the market across the board. The optimism in the wake of the Fed cut evaporated.

The tensions was increased when the Federal Reserve added a massive $US41 billion in temporary reserves to the American banking system overnight, the biggest one-day cash infusion since September 2001 and larger than anything injected during the depths of the August credit crunch. That was an attempt to steady the market and drive the target cash rate lower, without much success.

US investors will have a twitchy 24 hours as they wait on the US jobs numbers for October: a solid rise will settle nerves for a while, any sign of weakness will send confidence plunging. It’s probably too late to stop the Reserve Bank from lifting rates: yesterday’s strong retail sales probably made the rise certain, no matter what happens. But the fear of a second credit crunch in four months is now very real and very actively being canvassed.

And the jitters are showing up in the cost of short term money in Australia: Six month bank bills hit 7.20% yesterday, the highest for 11 years while 30 and 90 day bank bills are back at previous highs of 6.82% and 7.04%. While some of this is a reaction to the interest rate speculation here, it’s also a knock on from the credit jitters that have emerged in the past fortnight around the world.

European shares fell sharply, with London down 2% overnight and Barclays Bank tumbling over 5%. The shares in other European banks, such as UBS, Deutsche, UniCredit in Italy fell after Citigroup plunged 8% at the opening on news a banking analyst said the giant was short of capital and would have to cut dividend to rebuild its strength over the next few years.

Citigroup shares fell after a CIBC World Markets analyst downgraded the company’s shares, saying that Citigroup may have to cut its dividend in order to raise $US30 billion in capital. Citibank shares fell 6.9% lower at a four and a half year low.

News of the downgrade hit Citigroup shares, sparking fears that other major financial players were harder hit by this summer’s subprime crisis than originally anticipated. Bank America also fell when the same analyst downgraded its earnings because of its subprime problems. The shares in Credit Suisse and UBS fell as well on their big write-downs and losses reported earlier in the week rekindled fears they might have more losses to report next quarter.

Citigroup shares are now yielding 6.8%, a sign investors are growing nervous about the bank , its dividend and its future.

The worries about the health of banks, especially those reporting losses in the past few months, also weakened in the US and Europe, setting off a chain reaction of concern.

Besides the sharp fall in bank shares, the prices of insurers who insure mainstream debt instruments, such subprime mortgages and their associated credit derivatives fell. These include companies such as Radian, MBIA, Ambac and MGICA and the main concern is that they will not have enough money to cover potential losses as more and more subprime mortgages and their associated derivatives are downgraded or default.

These companies deny they have a problem but the cost of insuring their debts has risen sharply, especially as the leading follower of problem mortgages, RealtyTrac says the rate of delinquencies among subprime borrowers has accelerated sharply. This in turn has seen the three main ratings agencies slashed ratings on more than $US100 billion subprime mortgage backed bonds, with another $US70 billion on creditwatch for a possible downgrade.

US analysts say the problem now is that many defaults and downgrades are happening in the higher rated, AA and Triple A bonds which were supposed to be safe. That in turn is feeding the fears of further losses at UBS, where Merrill Lynch said there could be another $US4 billion in losses, Merrill Lynch and Citigroup, where more losses are also tipped, and other banks.

The continuing crisis and rising defaults on bonds (which won’t peak until next October, according to some forecasts) is pushing a key mortgage-linked derivatives index to new lows, threatening to unleash a further bout of credit market upheaval.