By Greg Peel

The Dow fell 353 points, or 2.3%, while the S&P lost 2.5% to 1588 and the Nasdaq dropped 2.3%.

The world is currently watching white-knuckled as a credit crisis emerges in China. The Chinese interbank lending rate, known as "Shibor" in deference to the developed world's interbank rate, the London interbank offered rate or Libor, jumped to 13.5% yesterday from 7.7% on Wednesday. Shibor is the rate at which Chinese banks lend to each other to finance day to day operations.

Observers have been quick to point out that as the GFC unfolded in 2007-08, Libor rates shot up and created the Credit Crunch that became the GFC, as credit markets froze on an unwillingness to lend. At that time the Fed and other central banks were quick to act with massive liquidity injections and, eventually, the TARP, but in this case the People's Bank of China has been standing idly by.

The squeeze is being orchestrated by Beijing in a latest attempt to rein in rampant property speculation and deflate the Chinese property bubble, and otherwise stop monetary stimulus intended to encourage domestic economic growth from flowing into off-balance sheet activities, high-yield bond investment and shadow banking. We recall that late last year the departing regime pumped significant amounts of liquidity into the interbank market as its preferred measure to arrest a slowing economy. What the Lord giveth...

The PBoC did step in yesterday, injecting 50bn renminbi into the system, but it was all to one bank. Other banks are now queuing up desperately for their own hand-outs, but the PBoC's policy of "targeted lending operations" suggests not all banks will be given a life-line. The liquidity squeeze is the latest attempt by Beijing to reform the Chinese economy, following on from crackdowns on pollution, which have hit manufacturing, corruption, which have hit retail spending, and export "over-invoicing" and currency speculation, which have hit trade.

In a worst case scenario, the liquidity squeeze could cause bank defaults and a run on deposits. In the scenario the world likes to believe will transpire, Beijing is fully in control and is simply shaking the tree. The timing is unfortunate, given yesterday's drop in HSBC's estimate of China's June manufacturing PMI to 48.3 from 49.2 spooked the world amidst the turmoil already created by the threatened withdrawal of the Fed's QE. The slowdown in China is clearly intensifying, and while Beijing's policy is for a lower, more sustainable level of growth backed by market reforms, global growth is dependent on a supportive China.

One might argue the case that a similar situation has been going on in the US, in which substantial central bank liquidity has not found its way sufficiently into corporate loans and job creation, but has instead fuelled a search for high yield investments outside the US, in locations such as Australia. When it was feared the Fed might turn off the tap, the money came rushing back. When the Fed confirmed on Wednesday night that it would start turning off the tap, it rushed back more.

Yesterday Bridge Street suffered somewhat of a perfect storm. Firstly, the Fed's taper confirmation sent the Aussie spiralling, and as stocks opened down in sympathy with a fall on Wall Street the foreign exit was on again. This time the bargain hunters (particularly for bank shares) wisely stood aside. Late morning, the Chinese PMI release caused more despair and a run on the miners. To top it all off, yesterday was index option and futures option expiry day in a session that saw the ASX 200 falling through several strike prices. Market-makers were forced to sell to cover, exacerbating falls and feeding the beast. The day ended with blood on the floor.

And let's not forget EOFY tax-selling.

Tonight in the US is "quadruple witching", in which stock options, index options, futures and futures options all expire. Over the past two sessions the Dow has fallen over 500 points and last night the S&P 500 fell through significant support at 1600, sparking an acceleration in the selling. US market-makers will also have been chasing the market down and adding to the stampede ahead of tonight's expiry. The expiry twist in the tale comes on top of what we might call the "Fed exit exit", as those who thought the US economy was not yet strong enough for the Fed to back off, bail out. And throw in Shibor concerns and general worries about a slowing Chinese economy.

Last night an equivalent flash estimate of the US PMI was released, indicating a fall to 52.2 from 52.3, with slower employment growth the stand-out element. The Conference Board leading economic index for May showed a rise of 0.1% when 0.2% was expected (albeit April's number was revised up to 0.8%). That was the bad news. Otherwise, the Philadelphia Fed activity index jumped to a much better than expected plus 12.5 from minus 5.2 in May, while sales of existing homes in May also beat expectations with a 4.2% increase to the highest level since 2009.

The eurozone's manufacturing PMI also rose to a better than expected 48.7 from 48.3 to mark the slowest pace of contraction in 16 months. The composite PMI, which adds in services, rose to 48.9 from 47.7.

I suggested yesterday that the smart money on Wall Street does not respond on the day to Fed statements, but rather sleeps on it and makes its move in the following session. Sometimes this means a turnaround, and sometimes not. The smart money has been waiting for a pullback on Wall Street since pretty much the beginning of the year, watching in bemusement as the S&P pushed to new all-time highs. Ahead of the Fed meeting, the S&P was almost back at all-time highs once more. A trigger was needed, and Bernanke delivered. The pullback is on. The last time the Dow fell over 300 points was when Obama won the election last year. The rout did not last long.

The smart money will not now attempt, to drag up a hackneyed expression from 2008, catch the falling knife. Those wanting to invest will wait for the panicked money to get out. The knife is also pretty sharp down here on Bridge Street.

Money continued to flow into US dollars last night, sending the index up 0.6% to 81.80. Money continued to flow out of US bonds, sending the ten-year yield up another 11 basis points to 2.42%. And it was goodnight for the hedge against monetary inflation. Gold fell US$72.80 to US$1277.80/oz. Gold has now lost a third of its US dollar value from its peak.

I noted yesterday that the LME had closed before the Fed statement was released, hence last night would see the true response. Throw in the weak Chinese PMI and Shibor concerns and we saw zinc down 1.5%, aluminium and lead down 2%, tin down 3% and nickel down 4%. Copper fell 3% and is threatening to break US$3.00/lb.

Oil has been supported by Middle East tension concerns and in many eyes had become overvalued against the demand-supply equation. Not anymore. Brent fell US$4.21 to US$101.91/bbl and West Texas fell US$3.29 to US$94.95.

The Aussie is down another cent from this time yesterday, at US$0.9201, but all of that fall (and more) occurred in yesterday's local session.

Despite all else, spot iron ore rose US60c to US$120.60/t.

The new September front month SPI Overnight is down 81 points, or 1.7%.

The S&P 500 has now wiped out all its May gains. Many on Wall Street were confounded by May gains in the first place. There may be more of a correction to come, but as at the close last night, the S&P was still up 12% in 2013. There's plenty of room to fall without killing off an otherwise positive trend.

The ASX 200 spent all of May falling as the foreign money pulled out, affecting a big divergence with Wall Street. There may yet be more foreigners to run for the boats, but one wonders just how far we're meant to fall on a Wall Street blow-off correction that has long been tipped. The ASX 200 is sitting on about square for 2013.

You have to have a giggle when you watch/listen to the mainstream media's coverage of the markets. For months the headlines have screamed blue murder over the strong Aussie dollar and the destruction of Aussie life as we know it. Now that the Aussie has tanked to a much more comfortable level, the headlines are screaming panic. Sure ? China is a worry, but the more the Aussie underperforms commodity prices (or outperforms to the downside) the greater the net benefit. And that's just the resources sector. The market in general is set for a big earnings upgrade.

Look out for an article today: Aussie Pain Is Stock Market Gain.

Also look out for a big rebalancing of the ASX 200 and other indices on the close today. More unfortunate timing.