A return of relative stability to equity and credit markets is unlikely to last long unless recently-intensified funding strains on money markets show signs of easing soon.

Many strategists, puzzled by this apparently contradictory trend on global markets, argue that the recovery in risky assets since mid-March may taper off as persistent stress in money markets would inflict wider damage on the real economy.

World stocks have rallied almost 10 per cent from their March lows to a three-month high due to action by leading central banks to contain the crisis, plus relief that first-quarter bank earnings escaped some of the worst fears.

Credit markets also rallied in tandem, with riskier corporate bonds outperforming safe-haven US Treasury paper in the past few weeks. In contrast, stress has been building up since mid-March in the wholesale funding market.

The cost of borrowing dollars in the medium term has leapt to a six-week peak as concerns grew that banks still face balance sheet problems due to their exposure to the US housing market.

Adam Myers, market strategist at Credit Suisse, argues that this disconnect is because equity and credit investors have a poorer idea of the underlying balance sheet problems at the banks, the epicentre of the credit crisis.

"Money markets are reflecting a level of caution which is not reflected in credit or equity markets," he said. "The difference between the two is that a money market trader has a much better idea of solvency of their trading counterparties than does an asset fund manager."

"Given money market traders' proximity to balance sheets, they get clear information from buying and selling of money between each other. The view of the equity and credit market is far too sanguine."

Myers noted that despite the S&P 500 index's rally to its highest level since January this week, the S&P 500 Diversified Bank Index - which reflects the health of US banks most exposed to the housing market - has languished not so far off January's 4-1/2 year low.

"The real economic effect of this credit crunch is only beginning to be felt. We are going to see a much more substantial impact than is reflected in equity and credit markets," Myers said.

In a sign that the real economy will feel the credit crisis, ratings agency Moody's noted that credit quality in western Europe deteriorated further in the first three months of 2008.

The gap between downgrades and upgrades of the region's credit issuers stood at -18 in the first quarter, with downgrades outnumbering upgrades. This is the worst outcome since the third quarter of 2006.

The 12-month rolling share of upgrades out of all western European credit ratings revisions also fell for both the financial and non-financial sectors.

Kenneth Lewis, chief executive of Bank of America which announced a 77 per cent drop in quarterly profit on Monday, summed up the mood. "It would be too early to strike up the band and sing 'Happy Days Are Here Again'," he said.

Analysts at Lehman Brothers label the April rally in risky assets as a "spring reprieve" against a backdrop of the still-gloomy outlook for the US and global economy.-Reuters

"Led by the US, the global economy's potentially headed for a stall. Corporate profitability has not reached its nadir. The depth of this economic/issuer correction has yet to be fully defined," Lehman said in a note.-Reuters