Montreal, Canada

Government bailouts of the financial system in 2008-2009 have resulted in a sovereign debt crisis this year as investors attack those nations with the biggest deficits.

First it was Dubai in late November 2009 and now it’s Greece. Spain or Portugal might be next. Maybe the United Kingdom. And what started out as a local crisis has now spread across the euro-zone while infecting not only the European continent but spreading contagion across world markets.

The month of May will probably rank as the worst month for global markets since October 2008 when the MSCI World Index crashed 19% at the height of the credit crisis. Thus far – and the futures this morning are outright ugly as major averages violate important support levels – May is looking outright ugly as the MSCI World Index sheds about 16%.

The usual winners are emerging in an otherwise sobering month for all risk-based assets.

Treasury bonds, German bunds, the Japanese yen, Japanese government bonds, the U.S. dollar and gold have all logged gains in May – a repeat performance of the deflation trade that engulfed markets two years ago.

The Panic of 2010 joins August 2007 as the starting point for renewed credit volatility.

Credit spreads have started to blow-out again across most markets with overnight OIS swap rates now the highest since early 2009. LIBOR in London has been rising all spring as dollar rates vary greatly across the 16 banks that form the overnight rate. Lenders are starting to balk again and that’s bad news for smaller companies and individuals who are already struggling to secure financing. Worse, central banks have already spent the bulk of their ammunition fighting the 2007-2009 crises; there’s not much left in their arsenal if markets don’t stabilize.

Yet Germany is the one to blame for this round of chaos. I imagine the German banking system is in dire trouble because last Tuesday’s unilateral decision by the German government to ban naked short-selling triggered a war against financial markets. Greece was a containable crisis. But Germany has gone too far banning free markets, a decision rendered I suspect in order to safeguard its fragile banks -- many up to their eyeballs in Club Med debt.

On top of this uncertainty we’ve got financial regulatory overhaul in the United States and Europe, a ban on hedge fund marketing and some trading strategies and a global bank tax on the way. None of this is conducive to propping a tired and exhausted post-March 2009 cyclical bull market in risk assets.

Unfortunately, deflation has the upper hand after all. Credit growth has stalled, money-supply growth has stalled and a new inter-bank lending freeze in Europe is spreading deflation. Not a pretty picture for investors.