Dow bounces back on hope of monoline rescue plan

US shares stage late recovery but FTSE 100 erases gains; Citigroup predicts recession

News that Wall Street banks are discussing a bail-out of stricken bond insurers sent US shares soaring last night, capping the most volatile day on financial markets since 2002.

On one side of the Atlantic, European stock markets, including London's FTSE 100, fell sharply as central bankers indicated they would not follow the US Federal Reserve in making dramatic interest rate cuts.

But on the other, the Dow Jones Industrial Average reversed a 300-point fall to close up by almost the same amount.

The sudden switchback occurred in mid-afternoon trading on Wall Street, when the New York state insurance regulator said he had held talks with major investment banks about a bail-out plan for the monoline insurance industry.

Monoline insurers have guaranteed $2.4 trillion of bonds, but are facing growing doubts over their ability to cover losses on complex mortgage-backed instruments such as collateralized debt obligations (CDOs).

If a monoline insurer collapses, or even loses its armour-plated triple-A credit rating, its guarantees could become worthless and Wall Street could be forced into another round of multi-billion dollar write-downs.

Reports last night suggested that the New York insurance superintendent was assembling a $15bn rescue fund to prop up the two main monoline insurers, Ambac and MBIA. Their battered shares shot up, and other financial stocks had led the US market 2.5 per cent higher by the close. The Dow Jones ended at 12,270.17, up 298.98.

Earlier, the FTSE 100 index closed 2.3 per cent lower, erasing most of the recovery it made on Tuesday. Minutes from the Bank of England's Monetary Policy Committee revealed that rate setters had voted 8-1 to keep rates on hold as inflation pressures overrode concern about the slowing economy. "Reductions in bank rate in two successive months might, given the current conjecture, encourage observers to think that the committee was focused more on stabilising demand than meeting the inflation target," the MPC minutes said.

The minutes showed the MPC falling in behind the message, delivered by the Bank of England's Governor, Mervyn King, on Tuesday. He warned that containing inflation would be the MPC's top priority this year as it faced the twin threats of rising prices and slowing growth. The economy grew at its weakest pace for more than a year in the fourth quarter, official figures showed yesterday.

The Dow Jones Euro Stoxx 50 index dropped 4.7 per cent after Jean-Claude Trichet, president of the European Central Bank, repeated his hardline stance on inflation. "Particularly, in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility," he said.

But bond investors bet that the ECB would be forced to cut rates. European two-year government notes made their big-gest gains since September 2001 and yields on June rate futures fell.

The furious debate over the Fed's move continued for a second day, with economists and traders split on whether it will be enough to avert or ease a severe slowdown. Steven Wieting, chief economist at Citigroup, is now telling clients to brace for a US recession. "We've cut the full year-2008 GDP outlook to 1.2 per cent from 2.4 per cent previously," he said. "The unemployment rate should climb to 6 per cent. Academic definitions aside, we'll call that recession. 'Mild but prolonged' seems more likely than 'quick and deep'."

John Lonski, chief economist at Moody's Investors Service, noted that the Fed's rate cuts are already being reflected in falling mortgage rates, but said the proof of the pudding will come in the spring. "That is the key selling season for new homes and when we would be looking to see if lower rates and lower prices can bring some stabilisation in the housing market."