It appears that inflation has replaced the credit crunch as the financial markets’ biggest worry. Although the markets’ collective attention may have waned, that doesn’t mean the risks have abated.

Despite evidence that credit markets are improving — spreads are narrowing and liquidity is returning — the outlook is far from worry-free. In fact, as the Bank of Canada notes, “Global credit markets remain very fragile.”

Specifically, the BoC is concerned that forced selling by leveraged investors may push asset prices lower once again.

But the biggest fear is the economic situation in the U.S.: if that recovery is weak and slow, the “adverse feedback loop” between the real economy and financial markets could intensify.

The bad news is that the U.S. housing market is far from recovered. In early June, Merrill Lynch & Co. Inc. reported that mortgage delinquencies hit an all-time high in the first quarter, as so-called “serious” delinquencies, which have the highest probability of falling into foreclosure, jumped sharply. More than one million homes are now in foreclosure.

“The flood of homes back onto the resale market will only add to the deflation in the real estate market,” the Merrill report notes, “a clear indication we are still far from seeing the last of the bad-debt write-offs in the banking sector. What is of even greater concern is how sharply delinquencies and foreclosures in the prime category are now rising.”

The Merrill report also notes worries about the long-term health of the Canadian housing market; house price increases in this country are outpacing income gains. The number of people spending more than 30% of their income on housing is rising. The surging popularity of longer-amortization mortgages suggests people must go to greater lengths to ensure they can afford their homes.

Nevertheless, the biggest worry is the continued fallout from the U.S. subprime crisis. The prospect of ongoing losses at the banks means credit conditions may stay tight for some time and that more work will have to be done to repair banks’ capital positions.

Moreover, says Adrian Blundell-Wignall of the Organization for Economic Co-operation and Development, there are some market segments, such as the $1 trillion in European equity structured products, that could yet prove vulnerable to the effects of the market turmoil.

Financial markets may be tired of hearing about the credit crunch, but they should have learned that ignoring these risks doesn’t make them disappear.

— JAMES LANGTON