Investors are looking to a meeting of the Federal Reserve on Tuesday for signs of further support for reeling financial markets and the economy after the European Central Bank stepped in to buy Italian and Spanish government bonds in the latest attempt to deal with the euro zone debt crisis.
Over the weekend the G7 and G20 group finance ministers pledged coordinated action to ensure financial market stability and economic growth after world stock markets lost $3.4 trillion in value since July 29 on investor concern that slowing global economic growth would make it even harder for heavily indebted countries to pay their debts.
Late Friday the United States lost its prized AAA credit rating from Standard and Poor's, reflecting the agency's fear that political gridlock in Washington, D.C would prevent the government from cutting its budget deficit and reducing its debt.
U.S. President Barack Obama on Monday said he hoped Friday's credit rating downgrade will give Congress a new sense of urgency to tackle the government's budget deficit.
Stock markets around the world fell further on Monday and investors rushed into safe-haven assets like U.S. Treasury debt, despite the U.S. rating downgrade, as well as gold. Gold soared to almost $1,720 an ounce in its biggest surge since March 2009. Major U.S. stock market indices were down about 5.0 percent by mid-afternoon after European stocks fell to a two-year low.
"The sell-off is mainly due to the fear that we will relapse into recession," said Klaus Wiener, chief economist at Generali Investments, which manages 330 billion euros ($468 billion). "Many investors have finally realized that the U.S. economy will not grow at 3.0 percent."
ECB TO THE RESCUE
In Europe, traders estimated the ECB bought about 2 billion euros in Italian and Spanish debt after it agreed on Sunday to broaden its controversial bond-buying program for the first time to include the bloc's third- and fourth-biggest economies.
After a rare Sunday night conference call, the ECB welcomed announcements by Italy and Spain of new deficit-cutting measures and economic reforms as well as a Franco-German pledge that the euro zone's rescue fund will take responsibility for bond-buying once it is operational, probably in October.
"It is on the basis of the above assessments that the ECB will actively implement its Securities Markets Program," ECB President Jean-Claude Trichet said in a statement.
The central bank action aimed to change the dynamics on bond markets that had been pushing Italian and Spanish borrowing costs up toward unsustainable levels since mid-July.
Since the program began in May last year it has bought just 76 billion euros of bonds, while Italy and Spain alone issue around 600 billion a year.
"The intervention by the European Central Bank this morning seems to have been working," Irish Finance Minister Michael Noonan told RTE public radio.
"Last week the risk was that as bond rates in Italy went toward 7.0 percent, they'd be driven into some kind of bailout program. They have fallen by almost one percent this morning so they are well out of the bailout territory now."
Spreads of Italian and Spanish bonds over German debt narrowed sharply and the cost of insuring peripheral European debt against default fell. But French sovereign credit default swaps hit a record high of 160 basis points as the U.S. rating downgrade raised questions about how long other AAA countries, such as France, could hold onto their top-notch ratings.
The ECB move was seen as only a temporary solution however, due to the sheer size of Italy's bond market -- $1.6 trillion.
Longer term, more profound measures need to be taken or some of the euro zone risks breaking up, some analysts said.
"They can keep it up for some weeks but I don't think it can have a lasting impact on the market," said Glenn Marci, interest rate strategist at DZ Bank.
However, European stocks sank to their lowest in nearly two years on Monday as doubt about governments' ability to deal with the euro zone debt crisis and its impact on economic growth emerged.
Berlin denied that Germany and France had made any stronger promises about the euro zone rescue fund's commitment to buy bonds of weak member states in the secondary market, after the ECB singled out that pledge.
A bailout of Italy would overwhelm the EFSF's existing resources. Germany has so far opposed expanding it but French Finance Minister Francois Baroin said: "The allotment is 440 billion and we've already said if we need to go further we will go further."
Over the weekend the Group of Seven major industrial nations -- the United States, Britain, Canada, France, Germany, Italy and Japan -- said they would take joint action if needed in foreign exchange markets because "disorderly movements ... have adverse effects for economic and financial stability."
A G20 communique along similar lines followed shortly after European markets opened.
The Japanese intervened to restrain their surging currency last week while the Swiss National Bank surprised with a new round of easing as it fought a rapidly rising franc.
Investors are now turning their attention to what the Federal Reserve might say at its policy meeting on Tuesday.
Although the Fed's meeting is not expected to produce any immediate change in policy, pressure is now growing on the Fed to try further monetary easing -- dubbed QE3 by the market.
The U.S. central bank completed a second installment of bond buying, or quantitative easing, worth $600 billion on June 30 and the Fed is reinvesting its portfolio as it matures.
"We are probably a little bit closer. But I don't think we're there yet," said Nomura's chief global economist Paul Sheard. "I think the Fed would have to get a little bit more concerned that financial markets were spinning out of control before accepting ... QE3."