Credit markets continue to experience turbulence, which tends to increase upon the release of the latest bad news and diminishes when there are comforting statements or actions by the central banks.

Safe-haven buying of Treasuries is still in vogue, particularly at the short end of the maturity spectrum. But it's not unusual to see quite a bit of volatility in treasury-bill yields or the yield of the two-year note, because expectations are revised frequently.

Central banks have been very busy furnishing liquidity to the market. Money-centre banks are reluctant to lend, trust is low and the commercial paper market for asset-backed securities has seized up.

The central banks have acted quickly to stabilise the financial system and prevent a breakdown.

They have lent substantial amounts to the banks and are on standby to take further measures as necessary. Of course, some of these loans have already been paid back, but the window at the central banks remains wide open. Interestingly, the Fed and the ECB did not impose a penalty rate for making the loans.

However, the Bank of England stuck to its guns and did not change its standing policy of charging one percentage point above the base rate. As for the Fed, it sent out a clear signal by cutting the discount rate a good fifty basis points. It has also announced that it is willing to accept all sorts of paper as collateral for providing loans.

A major problem for the authorities is that they do not know the extent of the problem. Structured credit products were sliced and diced extensively and distributed all over the world.

Cases of toxic-debt infection are popping up everywhere. Institutions or funds that thought they had bought investment-grade CDOs have found out that the quality stamp didn't mean much. The complexity of the derivative products and their wide distribution means that from the regulators point of view there is little transparency in the financial system.

The fancy derivatives were supposed to reduce risk exposure. But it has turned out that they were an excellent money-making scheme for investment banks and a losing proposition for those left holding the securities.

Mortgage brokers, too, made good coin from pushing loans to low-income households during the easy-credit period. Many people made lots of money over many years in the sub-prime sector. They have already banked their gains.

The losers are the sub-prime homeowners who may end up with no home and those funds and institutions left with toxic or near-toxic assets on their books when the merry-go-round stopped.

Remember, that right up to the time the crisis broke; many Wall Street analysts were still saying that the sub-prime problem was "contained". And, Henry Paulson, the US Treasury secretary was pretty much humming the same tune, only reluctantly accepting that there would be some impact on the economy.

Well, given his position, one is not surprised to hear such comforting statements, but as former CEO of Goldman Sachs he has better knowledge of the current risks in the financial markets than most Wall Street analysts and the Fed combined.

It is reported that, on a recent trip to China, he was proposing that they should buy more mortgage-backed securities.

Now, that's the kind of quality advice that the Chinese really need. Actually, they are quite capable of making mistakes on their own. The Bank of China, which is a commercial bank and not the central bank, revealed that it had approximately ten billion dollars of toxic debt on its books.

The current financial crisis has led to a lot of finger-pointing and blaming others. There is little doubt that, as a result, we will end up with changes in regulation and reporting requirements involving the central bank, hedge funds, credit-rating agencies and many others, in the US and elsewhere.

The credit-rating agencies have been lambasted for their failure to take account of the risks of structured products, and their easy way in assigning ratings. Colourful phrases have been used to describe AAA-rated paper, whose quality has turned out to be little better than the worst grades sold on the market.

Many buyers of the ostensibly high-grade debt had limited knowledge of the fancy structured products, though some of the big entities should have known better.

They bought on the basis of the credit ratings assigned by Moody's and Standard and Poor's. The problem is that the agencies don't really have extensive in-house knowledge to assess these complex structures and their best analysts have already left to work for Wall-Street firms.

In addition, there is the usual issue of a conflict of interest for the agencies. They are paid by the firms whose product they rate, and in the case of CDOs the remuneration was more generous than usual.

In the current round of finger-pointing and blaming, there is one entity that should be blamed above all others, and that is the central bank.

We have repeatedly stated that the substantial liquidity creation of the Greenspan years, and the reluctance to reverse it, would lead to headaches down the road. Moreover, it was not just the Fed that engaged in these risky policies. Other central banks followed in its footsteps.

It has been an experiment in pursuing maximum non-inflationary growth.

Luckily, circumstances have been particularly favourable because of the beneficial effects of rapid globalisation and the rise of China as an efficient producer of low-cost manufactured goods.

However, as excess capacity was used up and inflation risks rose, markets began to price in a faster pace of central-bank tightening. These fears were in evidence in the May-July stock market sell-off, last year. But, when it became clear that central banks were in no hurry to reduce liquidity, investors' risk appetite increased.

Central-bank policies of the past six years are responsible for the excessive leveraged risk-taking that is now undergoing a necessary correction. As many analysts have already pointed out, by furnishing liquidity to the markets, once again, central bankers are, in effect, bailing out those entities that have taken on excessive risk.

If a market system is to function efficiently, those who take good risk-adjusted decisions should be allowed to win and those who make mistakes should lose.

This is not an ethical issue but a principle of market and economic efficiency.

Central banks would be guilty of instilling moral hazard in the system by preventing a necessary correction in which many financial institutions will fail and funds will close. If such entities are prevented from suffering the consequences of their actions they will resume leveraging and excessive risk taking with the assurance that there will always be a safety net provided by the central banks. The policymakers would be introducing distortions and future instability into the system.

The history of central-bank policymaking shows that they are often subject to political pressure. Their practice is governed by expediency rather than principle. When they appear to be doing things correctly, it is frequently the case that circumstances are particularly favourable, not because policymakers have been very clever.

So, in the current state of things where the hazard of an economic slowdown is increasing, it is unlikely that moral hazard will be their prime concern.

Thus, a slant towards easier monetary conditions is in the cards. In effect, they will try to artificially inflate asset prices and prevent an economic slowdown. Checking for credibility, on August 7 the Fed said that inflation was a problem, and on the 17th , when they cut the discount rate, there was no mention of inflation, but an emphasis on downside risks to growth.

The political pressure on Ben Bernanke is already increasing. He has met the head of the Senate Banking Committee and also taken note of calls from various politicians to ease up.

When the interest-rate cuts finally arrive, they will be presented as a lifeline to struggling low-income homeowners, not welfare handouts for Wall Street. But this isn't going to fool the cynical and greedy people on the Street.

It is the old Greenspan "put" that some naïve people thought was no longer going to be played when he left the Fed. Over in Europe, the French president Nicolas Sarkozy, is also leaning on the ECB to go easy on interest rates.

Many hedge funds have had a rough time over the past month and some have gone belly-up. Funds that had posed as being low risk turned out to be anything but, while those that had promised low volatility bounced like a yoyo.

Consequently, industry reputation has taken a knock. There are bound to be disappointment expectations among investors and this is likely to show up at redemption time. Hedge-fund managers with a troubled performance are probably on their knees pleading with investors to stay and give them another chance.

Large-scale redemptions are very worrying for hedge funds because it tends to feed on itself. Mass redemptions will hobble a hedge fund manager's ability to implement his strategy effectively and regain lost ground. For investors, it may be rational to dump a fund that is expected to have large outflows because its performance will suffer. In the case of some managers, they may be forced to suspend withdrawals and close the fund.

Redemptions will also cause a spate of volatility in the markets. We have already experienced the untoward impact of hedge-fund activity on the markets over the past month.

As an example, let's just examine the effect of one strategy that became unstuck over the past month: statistical arbitrage.

Right off the bat we should note that the term 'arbitrage' is misleading because the method is definitely not risk free. The statistical relationship on which the models are based may break down if the environment changes in an unexpected way. And this is what happened sending the models into a tailspin.

Many hedge funds, as well as prop desks at banks, are engaged in statistical arbitrage, and the modelling methods are very similar.

Anybody with good quantitative skills can replicate such models (the writer of this article included). There is not much originality involved. The result is that the space has become very crowded. And when you add leverage to the strategy, the risk is multiplied.

The hedge funds had long and short positions in many of the same stocks. So when some highly-leveraged funds had to liquidate positions it resulted in anomalous stock-price movements.

As the unwinding proceeded, long positions were sold and short positions bought back. The consequence was that the comparatively attractive low-PE stocks that constituted the long positions fell sharply relative to high-PE, unattractive stocks, that composed the short positions.

As a result, supposedly market-neural funds suffered deep losses. It should be noted that some of the more flexible and opportunistic managers have succeeded in recouping a portion of their losses.

Currently, risk-taking appetite has diminished but is very much alive. We see it being revived at the slightest indication of an increase in liquidity and stabilisation of markets. As an example, take a look at the carry trade.

The yen strengthened significantly over the past few weeks as risk aversion grew, but when it became evident that central banks were willing to provide plenty of liquidity to the system, the currency has started to weaken somewhat.

The same thing goes for every other form of risk-taking. If the incentives are there, investors will respond.

Conditions in the US housing market continue to deteriorate, with a negative impact on household spending. The redoubtable American consumer is at last feeling the strain.

As a result the US economy will undergo further slowdown in the fourth quarter. We do not believe in the thesis that there is a decoupling of the global economy, such that the rest of the world will act as an engine to pull the US along.

Europe is also set to slow down while much of Asia depends on exports to Europe and North America. Consumer spending in Asia is not strong enough to act as a principal engine of growth for the world economy. As for Latin America, its commodity exports depend on the strength of global industrial production

The manner in which the central banks handle the current crisis will have a significant influence on the outlook for the economy and the financial markets for the next few years. If there is an attempt to bypass a corrective phase, to unduly boost economic growth and artificially sustain asset prices there will be a price to pay down the road in the form of excessive risk-taking, greater volatility and higher inflation risks.

Iraj Pouyandeh is a Strategist and Senior Portfolio Manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com