Challenging backdrop for markets in 2008

By Kristina Cooke

NEW YORK (Reuters) - Investors worldwide are facing the most uncertain outlook in six years as an intractable U.S. housing and credit crisis threatens recession, driving market volatility to extremes not seen since the Internet stock bubble burst.

The dollar is trading near its weakest levels ever, U.S. government bond yields are hovering around two-year lows, and stocks are struggling to find direction.

This week, the Bush administration outlined a plan aimed at slowing the wave of homeowner foreclosures stemming from the subprime mortgage crisis and preventing the U.S. economy from tipping into recession.

Bush's plan was unveiled on Thursday, the same day the Bank of England unexpectedly cut interest rates for the first time in more than two years, in order to shore up its economy in the face of a global credit crunch.

The Bank of England cut followed a surprise rate cut in Canada, suggesting that the economic fallout from the U.S. subprime mortgage crisis and subsequent credit crunch is not limited to the United States.

"The whole idea of decoupling has suffered some fairly mortal blows this week," said Jeremy Stretch, currency strategist at Rabobank. "It's inevitable that we will see a slowdown being spread across the globe."

Next week, Reuters will host some of the world's most successful and leading chief investment officers and money managers, at its Reuters Investment Outlook Summit in New York. Speakers include Pimco's Bill Gross, BlackRock's (BLK.N: Quote, Profile, Research, Stock Buzz) global chief investment officer for equities, Bob Doll; and David Einhorn, president of hedge fund Greenlight Capital. They will discuss how they plan to put their money to work in 2008.

On Tuesday, the U.S. Federal Reserve is expected to cut U.S. interest rates by at least a quarter percentage point.

Gross, manager of the world's biggest bond fund, recently warned that the Fed's federal funds target rate, currently at 4.5 percent, may need to fall to below 3 percent to restart a "near-recessionary" economy.

But Larry Smith, chairman and chief investment officer at Third Wave Global Investors in Greenwich, Connecticut, said that, while interest rate cuts will help, they "cannot fix the broader credit problem without evidence accruing that default rates do not rise as much as currently feared."

Another challenge ahead is the threat of global inflation, with $100 oil on the horizon, and with price pressures running high in China, Europe and the Middle East.

The concern about inflation prompted some European Central Bank policy-makers to argue for a rise in European interest rates -- the reason the bank decided to break with other banks and leave rates unchanged on Thursday.

Against a basket of six major currencies, the dollar is down about 9 percent .DXY in 2007. The euro <EUR=> is 11 percent firmer against the dollar, while the dollar is 6 percent weaker against the yen <JPY=>.

Short-term bond yields have fallen about 170 basis points since the start of the year, and the S&P 500 .SPX is up 6 percent.

(Editing by Jonathan Oatis)