On August 29 (as I write this), the euro is trading at $ 1.47. That is, over a period of 45 days, the European currency has shed about 9 per cent. Analysts are predicting much more erosion -- the same bunch who were predicting more euro strength in July are now predicting levels of below $ 1.40 over the next few months. Currency forecasters, as you can make out, are a rather fickle lot.

Oil prices have seen a similar pattern. When oil quoted at a historic high of around $ 148 to a barrel on the New York Mercantile Exchange in early July, there was no dearth of forecasts and theories that prices were headed higher, perhaps as high as $ 200 over the medium term. Today, the price is nearer $ 115 and the consensus among analysts is that the price is likely to fall below $ 100 in the near term.

Is this a silly season for the financial markets? Or is it the case that markets are going through a much-needed reality check and finally aligning with the 'fundamentals?'

One way to explain these sharp mood swings is to see them as manifestations of massive 'de-leverage.' Investors are no longer borrowing cheap and investing in higher-yielding assets like commodities or high-yielding currencies. They are doing just the converse. There are essentially two reasons for this. For one, money is no longer that cheap. Asian central banks have been tightening monetary policy over the last few months and such tightening has impacted on the cost of cash. The threat of high inflation has ensured that other major central banks like the European Central Bank and the UK's monetary authority have kept rates on hold. As a result, global liquidity has gone down a little.

That's just one part of the story. The contraction in liquidity has been happening for a while but de-leverage happened earlier. What seems to have tipped the balance this time is a sudden realisation in the markets that the rising cost of cash would hurt global growth. That, in turn, would impinge on the demand for commodities and high-yielding currencies.

A slew of weak data from the European economies, particularly Germany and the UK, over the last month coupled with some evidence of a slowdown in China seem responsible for this sudden change. German GDP for the second quarter actually contracted by about half a percentage point. It is also perhaps not just coincidence that the euro and oil sold off close to the Beijing Olympics. The build-up to the Games saw a burst of construction activity in China that propped growth. With the Games over, investors see a sharp fall in China's appetite for goods, particularly commodities.

In short, the belief that prices would continue to move north has given way to fears of bottomless fall in prices. Ditto for high-yielding currencies. Currency traders are now beginning to price in 'rate' cuts by hawkish central banks like the ECB despite high inflation rates. This could mean erosion in the yield advantage that these currencies had.

What is likely to happen if this de-leverage continues? The US dollar will continue to gain through the entire period. Traders and fund houses are likely to turn to dollar assets as safe haven, particularly US government bonds. As the US Federal Reserve and Treasury keep signalling to the markets that they are willing to pull out all stops to thwart financial collapse, the appetite for riskier financial assets in the US could revive.

Besides, US institutional investors are known to favour their 'home market' in periods of global economic stress and that means more demand for dollars. The bottom line is that non-dollar currencies will come under pressure in this phase and it might be irrational to expect any major reversal in the rupee's trajectory in the next few months.

Second, commodity prices and 'out-of-favour currencies' are likely to drop further, perhaps even below the levels that their underlying 'fundamentals' warrant. I would not be entirely surprised if oil moves sharply below $100 a barrel if the Organisation of Petroleum Exporting Countries fails to send a clear message that it is willing to cut production.

However, prices are unlikely to move on a one-way street. Periodic bouts of anxiety about the US financial system could lead to bursts of dollar selling and spurts in commodity prices and currencies like the euro. However, traders are likely to see these as opportunities to sell these assets.

'De-leveraging' is underpinned by marked slowdown in global growth. Both European and Asian macroeconomic headlines are likely to get worse before they get better. The US economy will certainly not be out of the woods in a hurry. This has major implications for the behaviour of certain asset classes. It is virtually impossible for equities as a class to do well in a scenario of dwindling global growth. Thus, irrespective of how the Indian economy fares or how attractive stock valuations look, the local stock market is unlikely to sustain large gains soon.

Finally, if commodity prices do move down as global growth falters, inflation pressures will come down. Most central banks can then focus on pushing growth up by cutting rates. Money will become cheap again and at the first hint of a revival in growth, investors will use the cheap cash to buy into this growth. Thus, asset classes like equities might see a sudden rally that could mark the return of a bull run. It might take a while for this to happen but turns in the market are known to be completely unexpected.

The author is chief economist, HDFC Bank [Get Quote]. The views here are personal.