LONDON, Oct 1 (Reuters) Financial markets could face wild swings and the dollar may fall further into uncharted territory in the fourth quarter as investors eye more U.S. interest rate cuts after the credit squeeze that started in August.
Emerging and commodity markets, and high-yielding commodity-linked currencies, may offer a silver lining, however, as the resilience of some economies helps the world to weather a storm triggered by a fallout in U.S. subprime mortgages.
Financial markets began the July-September quarter with a rosy picture for the global economy, which was enjoying the best growth in three decades. World stocks hit a lifetime high in July and other risky assets rallied broadly.
But a downturn in the U.S. housing market has raised concerns about the health of banks who might have had exposure to bad loans.
This has pushed up wholesale funding costs and threatened to seize up the entire financial system.
World stocks, as measured by MSCI, fell more than 10 percent by mid-August from the July record high, while benchmark U.S.
yields hit their lowest since January 2006. Volatility shot up to a 5-year high.
The market upheavals persuaded the Federal Reserve to follow up its surprise cut in the discount rate in August with a reduction in the benchmark and discount rates in September.
This, along with actions by other major central banks to inject liquidity in the tightened up money market, has eased investor jitters. By the end of the quarter, stocks had recouped most of the losses made in July to August.
CLOSE TO RECORD Stocks are now tantalisingly close to the July record peak and confidence is coming back as investors have bought into the idea the Fed will deliver more growth-supportive rate cuts.
''If the growth outlook worsens the Fed will do everything to protect the economy. So it is quite a good time to think about reflationary trades. We are optimistic about equity markets especially in emerging markets because they are much more independent of the U.S. now than in the 1990s,'' said Martina Mueller-Kamp, head of asset allocation at Zurich-based wealth manager VP Bank.
''Volatility will stay high and this uncertainty will last.
We still do not know where the problems will arise in the next months -- how much the damage will be, or how far housing prices will decrease.'' Emerging markets, meanwhile, have proved resilient. The MSCI emerging equity index hit consecutive record highs over the past week and the year-to-date gain is more than 32 percent. The main world equity index, by contrast, is up about 12 percent since January.
But the ''unknown'' factor is still preventing investors from buying risky assets aggressively.
''We feel that it would be premature to already declare the end of the financial market crisis. Instead, we stick to the allocation stance adopted in September and remain nothing more than 'guardedly optimistic','' Klaus Wiener, head of research at Generali Investments said in a note to clients.
''The unprecedented liquidity squeeze in the money markets is the result of a deep-rooted distrust between banks. To fully overcome this, it will take more than just an aggressive cut in U.S. policy rates.'' CHART-BREAKING MOVES Expectations for further U.S. interest rate cuts support riskier assets, but are damaging for the dollar as easing slashes the yield premium it offers.
On Monday, the U.S. currency hit a record low against a basket of six major currencies and an all-time trough beyond $1.42 per euro.
The index lost nearly 4 percent in September, more than doubling its year-to-date fall.
Energy and commodity prices are maintaining this year's strong trend, with gold hitting 28-year highs near $750 an ounce and oil surging past $80 a barrel to a record over the past week.
Steven Pearson, chief currency strategist at Bank of Scotland Treasury, notes that the Australian and New Zealand dollars and the South African rand have yet to hit new highs even with the MSCI emerging index and the benchmark CRB commodity index scaling record peaks.
''This suggests there is further scope for FX carry trades to rebuild,'' Pearson said.
REUTERS SR RN1551