After months of wishful thinking, investors are nervous again about financial markets and the world economy, and it may take a flurry of much better economic data to make them believe in a sustainable recovery.
Anxiety grew on Monday after the World Bank cut its 2009 global growth forecast, saying the world economy will contract 2.9 percent this year.
That added to a decline that has hit major markets identified with increased risk -- global stock markets, currencies such as the euro, and oil, copper, gold and other commodities.
All three recently hit multi-month highs -- U.S. stocks surged nearly 40 percent from a bear market low hit in March -- as markets bet the worst of the global financial crisis had passed and the world recession was easing.
But these moves stalled this month, leaving the benchmark S&P 500 .SPX in the red for the year at Monday's close.
The dollar has also clawed back some of the losses suffered when growing optimism sparked investors to buy the euro and higher-yielding, commodity-linked currencies such as the Australian dollar instead, while U.S. bond yields have retreated from this month's eight-month highs.
Markets have woken up to a world where a lot of the 'green shoots' arguments are starting to look very questionable, said Citigroup technical analyst Shyam Devani in London. The market is uncomfortable and price action is beginning to reflect that.
The next step, he said, may be a decent pullback in stocks, commodities and yields, and possibly a complete reversal of the greenshoot arguments.
Lena Komileva, G7 economist at Tullett Prebon in London, said a stock- and commodity-market rally was only partly driven by modestly improved economic data.
Instead, she said investors bruised and bloodied by last year's Lehman Brothers collapse and the subsequent deep freeze in credit breathed a collective sigh of relief this spring when near-zero interest rates and a sea of new money from central banks helped stabilize markets and put a floor under prices.
But stabilization is not recovery, and to have recovery we need to see the liquidity that generated the gravity-defying rally in equities and commodities and currency carry trades find its way into the financial system, she said.
DATA MUST SUPPORT RECOVERY HOPES
So far, that hasn't been happening regularly. The Federal Reserve has pumped money into the U.S. banking system, cut rates to zero and tried to control longer-dated rates through direct Treasury purchases, all with limited results.
What's more, households are in the process of selling or reducing debt, not borrowing and spending, said Hugh Johnson, chairman of Johnson-Illington Advisors in Albany, New York. It's hard to make a case for a recovery in those conditions.
Even if the U.S. economy starts to grow by year-end, he said the recovery will be anemic, with higher oil prices, long-term bond yields and mortgage rates all biting. I'd expect a 5 to 15 percent correction in stock prices and, candidly, I think 15 percent looks closer to the mark.
That will hurt sentiment, which will not improve unless the market sees a steady stream of stronger economic data from the United States, Europe and beyond.
The nice run-up in U.S. stocks that started in March -- I'm going to call that a correction, said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. Now we're back where we should be and the market will track the overall direction of the economy.
Optimism soared when a report showed U.S. employers cut fewer jobs than expected last month, but the jobless rate still rose to a 26-year high at 9.4 percent.
Over in the euro zone, the European Central Bank has warned of $283 billion in new bank asset write-downs.
Some have pinned hopes on China, which is expected to grow at more than 7 percent this year -- a sharp comedown from 11 percent but still robust compared to more developed markets.
Analysts note, however, that Chinese output is only a small slice of global output and say its export-driven growth model will struggle if U.S. and European economies remain sluggish.
TOUGH CHOICES FOR THE FED
BNP Paribas FX strategists said the Fed -- the U.S. central bank -- could help the economy by following the Bank of Canada's lead and making clear that it will maintain low interest rates for a long time.
We would expect such an approach to contain the rise in bond yields, which have in our view risen too far, too fast for this point in the cycle, they wrote in a note to clients.
But perpetually low rates would hurt the dollar, and any move to expand the Fed's $300 billion Treasury buying program to keep long rates low could raise inflation concerns, undermining foreign appetite for U.S. assets when the United States desperately needs creditors to buy its debt to finance a $1.8 trillion budget deficit.
Joseph Trevisani, chief market analyst at FX Solutions in Saddle River, New Jersey, put it bluntly: The Fed governors must decide which is more important: domestic interest rates or a stable dollar.