The weather is freezing cold across much of northern and central Europe and now in financial markets, where activity has slowed dramatically in the past two days, the credit chill returns.

Corporate bond markets are slowing to a near halt as temperatures fall and yields rise (and deals just stop), with Bloomberg reporting that volumes fell more than 60% last week. The chill is starting to repeat the spreading freeze in sovereign debt markets where Italy and Belgium took a hit overnight as the PIIGS of Europe became the BPIIGS.

Even in China, of all places, there were reports of a cash shortage and a sharp jump in market interest rates yesterday, which were taken as a signal that official rates would rise in the next few days. A near 4% fall in the market eased to a drop of just over 1% as nerves eased.

We could now be approaching the end game in the battle between markets and the eurozone over the value of sovereign debt, deficits and the position of the euro as the world’s second reserve currency.

It’s a battle; if it goes badly or is managed poorly, the world economy slump back into a credit freeze and recession in 2011. China, with its fading recovery, rising inflation and nervous government, is ill-prepared to meet a new slump. That means Australia is as well

The European Central Bank boss Jean-Claude Trichet recognises the dangers that have suddenly developed after Ireland’s bailout. That was supposed to have halted the speculation, just as the €110 billion rescue of Greece was supposed to.

In a speech to the European Parliament early today, Trichet made it clear the bank would defend the eurozone and its members.

“I don’t think that financial stability in the eurozone, given what I know, could really be called into question,” he said.

He indicated the ECB, which holds its usual monthly meeting Thursday night, our time, could step up its purchases of members’ debt. There were reports of growing purchases of Portuguese sovereign bonds in the markets overnight, which help calm the near panic among dealers as yields jumped sharply on Spanish, Italian and Belgian  after the Irish deal.

The ECB has so far spent €67 billion buying euro bonds this year, and has been supporting banks in Ireland, Portugal, Greece and Spain to the tune of well over a quarter of a trillion euros of loans a month.

Dealers now hope that tomorrow’s meeting will see the ECB make a clear statement of support for all other members, especially after the price of Italian sovereign and corporate debt fell, driving up yields and spreads over German bonds to all-time highs.

For investors and countries worldwide, it is now getting very serious and the global economy is starting to veer off course and head towards the same shoals that first grounded, then sank Northern Rock, Bear Stearns, and finally, the nastiest of all, Lehman Brothers, 26 months ago.

If Greece was Northern Rock and Ireland was Bear Stearns, who’s Lehman among the staggering sovereigns of outer Europe? There’s no shortage of candidates, Portugal and Spain are the ones of most likely, but this week we have seen Belgium and now Italy added to the list of possible victims.

As this morning’s Financial Times main editorial in its European and US editions said: “The European debt crisis took an ominous turn for the worse on Tuesday, sucking Italy closer to the whirlpool that has swallowed Greece and Ireland and is threatening to engulf Portugal and Spain.

“But the harsh reality is that Italy’s fate appears increasingly tied to that of Spain. For if Spain, like Greece and Ireland, required an emergency eurozone rescue, Italy’s portion of the bill would put its own finances under great strain. Italy, however blameless, would then itself be at risk. For the sake of the eurozone as a whole, the defence of Italy must start with the defence of Spain.”

If Italy is brought down, then the rest of the world can’t escape collateral damage.

The Reserve Bank has certainly spotted the danger. That’s one of the reasons interest rate rises are off the agenda. November had returned European instability to the forefront of official worrying at the central bank, especially these past two days.

Spain is the key; a smaller economy than Italy’s but one that will require a gargantuan back-up package if it’s needed, possibly one 6-7 times the size of the €85 billion bailout of Ireland.

If the crisis deepens, we will need our reviled banks more than ever, even in the first round of the crisis.

The GFC monster hasn’t stopped looking for victims, only paused since May.