A double-notch downgrade to Spain's credit ratings has piled more pressure on European leaders to make rapid progress on solving the region's debt crisis or face unbearable borrowing costs.
The fresh blow from Moody's Investors Service came just a day after the agency warned France its triple-A rating could be at risk and overshadowed a report that Germany and France were nearer a deal on leveraging the euro zone's rescue fund.
If the euro zone can't figure a way to handle the situation, you are going to see Spanish yields continue to go up, and they are going to have a problem funding themselves, said Jessica Hoversen, currency and fixed-income analyst at MF Global in New York.
Investors are counting down to a summit of EU leaders this weekend that was originally hailed as a watershed event.
Britain's Guardian newspaper on Tuesday said Germany and France had agreed to leverage the euro zone's bailout fund to over 2 trillion euros as part of a comprehensive plan but a senior euro zone source poured cold water on the report, telling Reuters that there had been no mention of such a deal.
The report initially caused a sharp rally in shares and the euro, only to be snuffed out by the downgrade to Spain.
Moody's cut the country's bond rating to A1, from Aa2, the third of the major agencies to act in recent weeks and taking it a notch below the ratings of Standard & Poor's and Fitch.
Moody's reasoning made worrying reading for those hoping for a speedy resolution to country's troubles.
Since placing the ratings under review in late July 2011, no credible resolution of the current sovereign debt crisis has emerged and it will in any event take time for confidence in the area's political cohesion and growth prospects to be fully restored, the agency said.
In the meantime, Spain's large sovereign borrowing needs, heavily indebted banking system and challenging growth outlook left it vulnerable to further downgrades, a judgment that would encompass all too many of EU members.
PINCH OF SALT
The Guardian, citing senior European Union diplomats, had reported the euro zone would endorse a five-fold increase in the 440-billion-euro bailout fund to help troubled governments and banks survive should Greece or any other member default.
The much-touted idea would be for the European Financial Stability Facility to insure the first 20 to 30 percent of any losses on new government debt.
Brian Dolan, chief strategist at Forex.com in Bedminster, N.J., said an expanded $2 trillion bailout fund would be about the right size to restore come confidence.
But he added: I have to take it with a grain of salt. We've seen a lot of these European reports that something was imminent only to be disappointed the next morning.
Indeed, German policymakers have been doing their best to play down the chances of a ground-breaking deal anytime soon.
German Chancellor Angela Merkel on Tuesday warned that leaders would not solve the debt crisis at a single meeting.
These sovereign debts have been built up over decades and therefore one cannot resolve them with one summit but it will take difficult, long-term work. Nonetheless, I do think we will also be able to take relevant, important decisions, she said.
Markets have been on edge for fear European leaders would not agree on a plan to address the crisis, which has already forced Greece, Ireland and Portugal to seek bailouts and has driven up borrowing costs in Italy and Spain.
France saw its borrowing costs jump on Tuesday after Moody's warned it may slap a negative outlook on the country's Aaa rating in the next three months if slower growth and the costs of helping to bail out banks stretch its budget too much.
Economy Minister Francois Baroin insisted the rating was not at risk but acknowledged that the 1.75 percent growth forecast on which the government had based its 2012 budget was over-optimistic and would have to be revised down.
The triple-A is not in danger because we will be even ahead of schedule on passing deficit reduction measures, Baroin said on France 2 television.
We will do everything to avoid being downgraded.
(Additional reporting by bureaus in New York, Paris, London, Frankfurt and Brussels; Writing by Wayne Cole, editing by Mark Bendeich)