Jumpy Markets Tank on China, Bernanke Hangover

A bank crisis an ocean away and a week-old announcement are dragging down U.S. investor confidence.

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China's stock market woes are tied to a liquidity crisis in that country.

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Just when it seemed like markets had calmed down from last Thursday's plummet, investor worries are back. As of midday Monday, the Dow Jones Industrial Average had fallen over 220 points, by 1.5 percent, and the S&P 500 was down by nearly 2 percent.

The plunge wasn't prompted by new revelations about the U.S. economy – it's not that any major economic indicators suddenly pointed downward, nor were there any new policy announcements. Rather, U.S. markets were in part reacting to stock markets on the other side of the world. China's Shanghai Composite index fell 5.3 percent Monday, its largest decline since August 2009.

China's stock market woes are tied to a liquidity crisis in that country. Interbank lending rates in China soared late last week, sparking fears that frozen credit markets would threaten the nation's economic growth.

[READ: China Slump, Bond Yields Weigh on Markets]

"The main concern is that the short-term credit crunch is going to result in a dram slowdown in China's economic growth, which will be bad for the global recovery, which will be bad for the U.S.," explains Nicholas Lardy, senior fellow at the Peterson Institute for International Economics and an author of several books on China's economy.

As China is one of the worlds' largest economies and among the U.S.'s largest trading partners, its economic fortunes are closely entwined with that of the U.S.

Coupled with China's stock volatility is lingering uncertainty from last weeks' Federal Reserve Open Market Committee Meeting, after which Chairman Ben Bernanke signaled that the central bank might start to taper its monthly bond-buying program, known as QE3, before the end of the year.

As QE3 has helped to boost the stock market, that announcement prompted the Dow Jones Industrial Average's largest one-day drop since 2011, with the index shedding 353 points last Thursday. Yields on 10-year Treasury bonds have, meanwhile, spiked, from below two percent just a month ago to nearly 2.6 percent as of midday Monday.

[ALSO: China Credit Squeeze Eases Slightly]

Still, there may be good reason to think investors are overreacting.

Lardy, for his part, thinks that the China cash squeeze is a short-term problem with minimal effects.

"My view is that this is not likely to have a huge effect on China's economic performance this year," he says. He says the central bank caused a spike in short-term rates as a way of cautioning banks to be careful with their borrowing and lending.

"I think the central bank now feels quite confident that the commercial banks have gotten the message," he adds.

Likewise, some equity analysts are feeling confident that the Fed will hold off on tapering. Ben Bernanke has said tapering would be contingent upon labor market health and economic growth, and many analysts have characterized the Fed's economic forecasts as too sunny. If growth is slower than the Fed governors predict, that may mean a delay to pullbacks in quantitative easing.

[DEBATE CLUB: Should China Be Considered America's Number One Adversary?]

"I don't think they're even going to taper this year. I think the FOMC's expectations are too optimistic," says Scott Wren, senior equity strategist at Wells Fargo Advisors.

He also takes a broad view of market performance, which shows a stock market stronger than recent declines might suggest. Since November's large dips, the Dow Jones Industrial Average has recovered by more than 2,000 points.

"We're still having a good year. The market was probably due for some sort of pullback," says Wren. Even given recent volatility, he adds, it may still be a good time for investors to jump in. "We've been telling our clients for two years that any pullbacks are buying opportunities."

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