For almost two months, financial markets have been embroiled in a bloody war. Last week, an uneasy truce descended—largely because of increasingly generous action by the world’s central banks. Not only did the US Federal Reserve cut rates by half a percentage point, but the UK authorities rushed to the aid of Northern Rock, a mid-sized bank that was facing a frightening run on deposits. Four investment banks also reported results that ranged from extremely good (at Goldman Sachs) to not a total disaster (at Bear Stearns).

It is tempting to hope that the worst is over. But this truce is extremely fragile. Conditions in the money markets are improving—but only slowly. So it could take months to get back to normal. During that period, there are any of a number of ways that hostilities could flare up again. But look first at the good news. Liquidity is gradually flowing back into the system. At the height of the crisis, banks were hoarding cash. But that process may be near its end. The boss of one big bank says he accumulated cash reserves of $25 billion (Rs99,500 crore) during the crisis but now he feels he has enough liquidity. If you fear a famine, you stock the pantry with baked beans. But when the pantry is full, there’s no need to keep hoarding.

Meanwhile, institutions that do have cash—like mutual funds—are becoming a bit more willing to lend it out for longer periods. During the hot phase of the crisis, few people wanted to part with their cash for more than a few days or weeks. Now there are tentative signs that people will lend for periods of aroundsix months. The sense of crisis is also receding from the commercial paper market. Borrowers who had been relying on funding themselves with such short-term money (often to invest in asset-backed securities such as mortgages) had to turn to their banks for funding instead. The amount of commercial paper outstanding collapsed by $200 billion in a few weeks. It is still shrinking but only at a trickle.

Finally, the gloom is lifting in the leveraged lending business. Credit spreads, which ballooned during the crisis, have retraced about one-third of their journey.

So why is the market still fragile?

To start with, less than 10% of the $100 billion or so of losses expected from reckless US subprime lending have been recognised. Even if the US housing market does not deteriorate further, that suggests a steady stream of salvos on still jittery markets. And thanks to the interlinked nature of modern global finance, the actual losses are likely to keep popping up on unexpected fronts. Another run on a bank in another part of the world could get everybody reaching for their tin-hats again. There are also two big macroeconomic risks. First, a housing-led recession in the US, as loan defaults provoke foreclosures driving prices down. The Fed’s actions haven’t removed the possibility.

Meanwhile, the bad news of the last two months has forced companies right across the world to start planning for the possibility of an economic slowdown. The risk is that recession planning could become self-fulfilling. If it does, a wide range of asset prices could resume their downward lurch. That would cause further losses by leveraged institutions such as hedge funds, more dumping of assets at distressed prices and more credit jitters. Second, US inflation could perk up. Bond markets are already getting worried that the Fed’s aggressive interest rate cut could have that effect.

Given the US’ continued reliance on borrowing money from the rest of the world to finance its huge current account deficit, that makes the dollar vulnerable.

If there is a buyers’ strike by international investors worried about US inflation, the greenback’s graceful fall could turn into a rout. Last week was a good one for the money markets. But it is still far too early to relax.