A European summit deal to strengthen budget discipline in the euro zone failed to restore financial market confidence on Monday, forcing the European Central Bank to step in again gingerly.
The euro fell, stocks slid and borrowing costs for Italy and Spain rose as investors weighed the outcome of last week's summit that split the European Union, with Britain blocking treaty change and forcing euro zone countries to negotiate a fiscal accord outside the Union.
Friday's initial market rally quickly petered out due to legal uncertainty surrounding the new pact and the absence of an unlimited financial backstop for the single currency.
French President Nicolas Sarkozy said the legal basis of a new accord to enforce debt and deficit rules in the 17-nation euro area with quasi-automatic sanctions and intrusive powers to reject national budgets would be worked out before Christmas.
In the next fortnight, we will put together the legal content of our agreement. The aim is to have a treaty by March, Sarkozy told newspaper Le Monde in an interview.
Euro zone crisis graphics http://r.reuters.com/hyb65p
An EU diplomat said the first draft of the new treaty would be ready by early next week. Sarkozy said the aim was to have it ratified by all member states except Britain by June.
You have to understand this is the birth of a different Europe - the Europe of the euro zone, in which the watchwords will be the convergence of economies, budget rules and fiscal policy, the French leader said.
Traders said the ECB intervened to buy short-term Italian debt after yields on Italian and Spanish debt spiked.
The central bank revealed on Monday it had slashed bond purchases in the week before the EU summit as it raised pressure on the bloc's leaders to act. It bought just 635 million euros in bonds in the week to December 9 compared to 3.66 billion the previous week.
ECB sources told Reuters on Friday purchases would remain limited, with no prospect of a big bazooka to shock markets.
Italian 5-year bond yields shot up above 7 percent, widely seen as a danger level while 10-year yields spiked above 6.8 percent and Spanish 10-year yields topped 6 percent.
Investors' appetite for short-term paper drove Italian one-year borrowing costs down just below 6 percent at an auction but yields remain uncomfortably high.
The major ratings agencies could make matters worse.
Sarkozy prepared French voters for a possible downgrade of the country's AAA credit rating but insisted he could cut the deficit without cutting salaries and pensions.
Moody's Investors Service said it intends to review the ratings of all 27 members of the European Union in the first quarter of 2012 after EU leaders offered few new measures to resolve the crisis at their summit on Friday.
Fitch Ratings said the summit failed to provide a comprehensive solution to the crisis, thus increasing short-term pressure on euro zone sovereign ratings.
Standard & Poor's, which warned last week of a possible downgrade of 15 euro zone countries shortly after the summit, still has to announce its decision.
But its chief European economist, Jean-Michel Six, told a business conference in Tel Aviv: Time is running out and action is needed on both sides of the equation, on the fiscal and monetary side.
If some of the euro zone's AAA-rated members are downgraded, it would call into question the solidity of the euro zone's rescue fund, which would likely suffer a similar fate. Its permanent successor will not come on stream until mid-2012 at the earliest.
We have a nice agreement: a fiscal compact, commitments to keep fiscal deficits down. But, actually, does any of this solve the euro crisis? No it doesn't, said Victoria Cadman, economist at Investec in London. We still sit here searching for the big bazooka solution.
The euro area faces the next potential crunch point in mid-January when Italy, which has a debt mountain of 1.9 billion euros or 120 percent of its annual output, has to start issuing tens of billions of euros in bonds towards a 2012 total of 340 billion euros needed to roll over maturing debt.
Political aftershocks from Friday's historic rift between Britain and the rest of the 27-nation bloc continued to shake Europe, with Prime Minister David Cameron facing tension in his coalition and doubts in the business community.
Cameron was given a hero's welcome by Eurosceptics in his Conservative party but faced a backlash from his Liberal Democrat coalition allies after he wielded a veto that has cast Britain adrift from its continental partners.
Britain remains a full member of the EU and the events of the last week do nothing to change that, he told parliament.
In a defiant statement, he told lawmakers he made no apology for having demanded safeguards for the City of London financial centre in any new EU treaty.
LibDem Deputy Prime Minister Nick Clegg said on Sunday he was bitterly disappointed with an outcome that would diminish Britain's global influence and was bad for jobs and business. Clegg was conspicuously absent during Cameron's address.
In Brussels, officials were groping for a strong legal basis for the planned fiscal compact, with Britain arguing that the euro zone cannot use the EU treaty institutions - the European Commission and the European Court of Justice.
European Economic and Monetary Affairs Commissioner Olli Rehn said most of the measures to strengthen budget enforcement could be implemented immediately under a set of rules known as the six-pack agreed in October.
He said he regretted Britain's decision and warned London: If this move was intended to prevent bankers and financial corporations of the City from being regulated, that's not going to happen. We must all draw the lessons from the ongoing crisis and help to solve it and this goes for the financial sector as well.
The crucible of the crisis, Greece, could yet cause havoc if negotiations over a second bailout fall apart, leading to a rapid default.
Greek Finance Minister Evangelos Venizelos said he wanted to move fast in talks with the EU, IMF and bankers, reaffirming the aim of clinching a voluntary debt restructuring deal by end-January before the country heads to elections.
We will proceed smoothly and with the maximum possible speed, Venizelos said after separate meetings with the head of bank lobby IIF and with EU, IMF and ECB inspectors, on key aspects of a 130 billion euro bailout plan.
EU leaders have now said banks may not take a hit in any future sovereign rescues after they were roped into the Greek bailout, a move which proved a final straw for many investors.
Commerzbank and the German government have been in talks for several days over possible state aid, five people familiar with the matter told Reuters. The lender, 25 percent-owned by the government, wants to avoid forced recapitalisation but needs to find 5.3 billion euros in capital by mid-2012 to meet new European capital rules.
(Additional reporting by Alexandra Za in Milan, Keith Weir and Sudip Kar-Gupta in London, George Georgiopoulos in Athens and Walter Brandimarte in New York; Writing by Paul Taylor/Mike Peacock; Editing by Alistair Lyon)