The euro fell to a 16-month low and world stocks dropped on Friday on talk that Standard & Poor's was set to downgrade the ratings of several euro zone countries.

But markets appeared to take the reports without too much worry. Stocks traded down but were off their lows for the day.

The downgrade reports were the latest blow to the region, which has been mired in a debt crisis and appears headed for recession.

Things have not been improving in Europe. The timing is not perfect, it is sort of like kicking someone when they are down, said William Larkin, fixed income portfolio manager at Cabot Money Management in Salem, Massachusetts.

Four euro zone government sources said S&P would cut several of the currency bloc's sovereigns and would make an announcement after New York markets closed at 4 p.m. EST (9 p.m. British time).

The downgrades would affect France and Austria but not Germany or the Netherlands, the sources said. S&P declined to comment.

The euro, which touched a fresh 16-month low, was last down 1.3 percent at $1.2664 against the U.S. dollar. The dollar <.DXY> was up nearly 1 percent against a basket of currencies.

World stocks as measured by the MSCI World Equity Index took off 0.7 percent after earlier falling more than 1 percent. Major U.S. indexes dropped almost 1 percent, but eased from session lows.

The Dow Jones industrial average <.DJI> was down 115.94 points, or 0.93 percent, at 12,355.08. The Standard & Poor's 500 Index <.SPX> was off 13.09 points, or 1.01 percent, at 1,282.41. The Nasdaq Composite Index <.IXIC> dropped 24.20 points, or 0.89 percent, at 2,700.50.

The European debt turmoil weighed on trading and corporate deal-making at U.S. bank JPMorgan Chase & Co , which reported a drop in quarterly income and was the first big U.S. financial company to report quarterly results. Its shares were down 3.3 percent at $35.65.

The FTSEurofirst 300 <.FTEU3> index dipped 0.1 percent.

ITALIAN DEBT SALE OVERSHADOWED

The S&P talk overshadowed a lacklustre sale of Italian debt.

Underpinned by a flood of European Central Bank (ECB) three-year loans to banks, Italy's three-year debt costs fell below 5 percent for the first time since September in an auction, spurring hopes it would make it through a stretch of looming refinancing.

But demand was weaker than a sale the previous day by Spain, the other major euro zone economy on the front line of the crisis.

U.S. bond prices rose as investors sought perceived safe-haven assets. The benchmark 10-year U.S. Treasury note was up 21/32, with the yield at 1.8514 percent, while German Bund futures hit a new record.

CREDIT DOWNGRADE TALK ALSO WEIGH ON GOLD, OIL DOWN

Gold fell as the dollar surged against the euro, sparked by the downgrade reports.

Spot gold was down 0.9 percent at $1,634.56 an ounce.

The dollar seems to be the main go-to safe-haven play at the moment, said David Meger, director of metals trading at futures brokerage Vision Financial Markets.

Oil prices also fell. Brent February crude was down $1.24 at $110.05 a barrel.

(Reporting by Caroline Valetkevitch, additional reporting by Richard Leong and Frank Tang in New York; and John Stonestreet, Richard Hubbard, Neal Armstrong and Marius Zaharia in London and Robin Emmott in Brussels; editing by Kenneth Barry and Jeffrey Benkoe)

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