Italy and Spain's borrowing costs fell on Monday as reports filtered in that the European Central Bank was buying their bonds, lifting European shares and partly overcoming jitters about a rating downgrade for U.S. debt.
Five-year yields in Italy and Spain fell more than 80 basis points. Spreads with German debt narrowed and the cost of insuring against default dropped.
Gold nonetheless soared to a new record above $1,700 an ounce on safe-haven buying and the dollar weakened against a basket of major currencies.
Investors were digesting a weekend of talks between industrialized countries aimed at ensuring the smooth functioning of financial markets following agency S&P's cut in its U.S. rating late on Friday to AA-plus from AAA.
Focusing on the euro zone crisis, the ECB agreed to intervene in the Italian and Spanish debt markets to reduce borrowing costs that are close to prohibitive.
The downgrade to the U.S. is not great. These markets are going to remain unsettled for a while, we had recommended investors to raise cash in anticipation of this volatility, said Mike Lenhoff, chief strategist at wealth manager Brewin Dolphin.
If the ECB is going to provide some support to the bond markets that could create some sort of relief, buying opportunities could emerge in the sold off cyclical areas, but we are looking for more stability first.
MSCI's all-country world index was down slightly, recovering as Europe gained. Last week's heavy bout of risk aversion chopped around $2.5 trillion off the value of the index.
Emerging market stocks were still being hit, losing around 2 percent on Monday.
European shares, as measured by the FTSEUrofirst 300 index shrugged off opening losses and moved into positive territory, rising a quarter of a percent as news filtered in that the ECB was buying Italian and Spanish bonds.
The ECB moves followed criticism last week that the bank had not addressed pressure on Spain and Italy when they bought Portuguese and Irish debt last week.
Traders said Monday's buying was focused on the 5-year sector of the curve, where Italian yields dropped to around 4.6 percent, while the Spanish equivalent was around 4.5 percent.
They're doing 20 to 25 million (euro) clips and they're spreading it around the market, said a trader. We expect them to do billions today.
The euro rose against the dollar and trimmed losses against other currencies.
The U.S. currency fell across the board after the S&P downgrade, struggling around record lows against the Swiss franc and the yen.
But the euro's gains were limited, and some analysts expected it would struggle to gain significantly, as bond purchases, while adding temporary liquidity to stressed bond markets, would do little to improve the fiscal problems in the region.
(ECB bond buying) will have a short term effect. It won't have any lasting positive impact on the euro, said Richard Falkenhall, currency strategist at SEB in Stockholm.
Even if the ECB buys Italian bonds, private investors will just sell and off-load their Italian risk ... The ECB will have to buy those bonds constantly just to keep yields stable, he said.
(Additional reporting by Naomi Tajitsu, William James, Kirsten Donovan and Dominic Lau; editing by Patrick Graham)