LONDON (Reuters) - The bell has sounded for round two. After treating the credit crunch as a financial, not economic threat, investors are now pricing in everything from a significant global slowdown to a full-fledged growth recession.

Suddenly, as well as worries about hidden debt time bombs in the world's largest investment banks there is widespread fear that second round effects, starting with US housing, are repainting the benign backdrop that had been relied upon to see markets through.

Plenty of economists and analysts believe the threat is exaggerated and that markets are ahead of events, but investors don't seem to be listening.

Volatility is back with a vengeance, short-term interbank lending rates are soaring, safe-haven bond yields are tumbling and stock markets have had a brutal month.

Citi's world government bond yield — a composite designed to give a global snapshot — has been at year lows for most of the month and is 75 or so basis points off its year highs.

Benchmark 10-year US Treasury yields have also tumbled from post-credit crunch levels and have reached lows that Wiener reckons are close to pricing in a US recession.

At the same time, stock markets have fallen sharply, interspersed with days of soaring gains usually tied to expectations of lower interest rates to combat economic trouble.

Major indexes from MSCI's world benchmark through the US S&P 500 to Germany's DAX and Japan's Nikkei are in negative territory for the month. Many year-to-date gains have been chopped away. "A high risk of US recession is getting priced into markets, especially in financials' credit spreads," JP Morgan said in a note, adding that markets were "in virtual panic mode." The trigger for much of this is the view that the earlier chaos in credit markets is now spilling over into the global economy, risking recession in the United States, a worse than expected slowdown in Europe, more struggles for Japan and milder dislocations in emerging markets.

A freefall in US housing activity, for example, looks to be threatening crucial consumer confidence. US consumer sentiment is at a two-year low, only just above where it was after Hurricane Katrina, according to the Conference Board.

David Rosenberg, Merrill Lynch's North American economist, suggests US corporate earnings are already in recession, with S&P 500 earnings-per-share down 8.5 percent year-over-year. In the euro zone, meanwhile, growth in the dominant services sector has fallen to more than two-year lows and EU officials are warning of slower overall growth than expected next year.

"All of this is starting to make clients nervous," said Ian Harnett of advisers Absolute Strategy Research.

Earlier investor axioms that the US consumer would not be affected by the credit crisis, that the rest of the world could remain above it and that equities could go their own way are turning into myths, he said. Investor sentiment gauges generally support this view. UBS says risk aversion is "extreme" among many investors, for example, while State Street's global investor confidence index is at its second lowest level in more than 9 years.

There is a view, however, that financial markets are getting ahead of themselves, that the economic picture is not as bad as current asset levels would suggest.

"Markets seem to us overly pessimistic," said Michael Dicks, head of research and investment strategy at Barclays Wealth. "It is not by any means inevitable that consumers are going to rein in buying beyond Christmas."

For all the poor economic reports, there have been more positive ones, such as Germany's Ifo business sentiment, euro zone and US manufacturing and the US labour market.

Most forecasters also still reckon that the US economy is likely to avoid recession, even if the chances have risen.

A poll of forecasters by the Philadelphia Federal Reserve, for example, suggests only a roughly 20 percent chance of "negative growth" in each quarter of next year. JP Morgan estimates the chance at 35 percent, which, while "uncomfortably high," still means 65 percent chance of positive growth.

Nonetheless, the risks are there and the investor mood heading in to 2008 is such that a new risk may be arising.

Investment bank ING reckons that market turmoil itself is now threatening economic growth. In other words, the reaction to perceived economic risk may become self-fulfilling.

Ding, ding. Round three.