The wolf pack is back

Markets: That didn't last long. Less than a week after European lawmakers and central banks averted financial Armageddon with a 750 billion euro bailout and a government bond buying spree, the euphoria seems to be waning.

Interbank rates and credit default spreads are rising, while equities are falling. A return to the pre-bailout trauma isn't imminent. But high deficits and the need for austerity will keep markets choppy.

Sure, market indicators are far from the flashing red signals of last week. The spreads between Euribor and overnight index swap rate -- a measure of banking sector stress -- was 34 basis points this morning, down from a peak of 45 basis points before the bailout. The SovX credit-default swap index, a gauge of government default risk, is about 50 basis points below its pre-rescue high of 175 basis points. And despite an early sell-off on Friday, European stocks are still about seven percent above their lows of the previous week.

Nevertheless, some of the sheen has come off the euro zone bailout. The overarching worry is that Europe's sovereign crisis is still at an early stage. European central bankers insist a Greek default is impossible, but Deutsche Bank's chief executive talks about it openly. By supporting Greece and the weaker euro zone states, authorities may simply be contaminating stronger ones.

The softening isn't just tied to European government worries; U.S. jobless claims figures, released on Thursday, were worse than expected. Nevertheless, European governments now face a balancing act between pushing through harsh austerity measures to regain control of their finances, and stifling economic growth, which would extend the pain and hurt corporate earnings.

But if political will to reform fails, the fall-back option could be even more buying of government bonds by central banks, ultimately leading to inflation. In the short term, markets will remain volatile as politicians try to keep their voters on side whilst inflicting spending cuts and tax rises. Reasons for optimism are thin on the ground.