Global stocks and the euro waned on Tuesday after S&P warned of a possible downgrade for 15 euro zone nations, though analysts expressed cautious hope the move would spur European leaders into more decisive action to tackle the region's debt crisis.
Even so, the optimism was tenuous and measures of financial risk remained elevated with banks increasingly reluctant to lend to each other.
With action muted in the stock market, there were other signs that investors were seeking safety as an auction for U.S. four-week or one-month debt saw record demand.
Standard & Poor's warned late on Monday it could cut credit ratings across the euro zone, including the top-tier ratings of Germany and France, the region's two biggest economies, underscoring just what is at stake ahead of a European Union summit this week.
It could also help Germany and France force through proposed treaty changes that would allow the imposition of mandatory penalties on countries that exceed deficit targets.
The plan unveiled on Monday to increase fiscal integration between European countries is promising and could help avoid a mass downgrade of euro zone countries by Standard & Poor's, a director with the ratings agency told Reuters Insider on Tuesday.
The timing of S&P's announcement and the inclusion of euro zone economic powerhouse Germany among the 15 countries facing a ratings cut put the focus firmly on the need for this week's EU summit to deliver.
If the European leaders come up with something concrete, we could expect a bit of euphoria, but that would be sustainable only if it could be implemented, said Felicity Smith, fund manager at Bedlam Asset Management.
A ratings downgrade could automatically require some funds to sell bonds of affected states, making those countries' borrowing costs rise still further.
It could also make banks less willing to lend to each other, leading to a credit squeeze. On Tuesday, the spread between three-month euro Libor rates and overnight indexed swap rates - an indicator of financial stress - stood at 92 basis points, near an almost three-year high of 93 basis points hit on December 1.
U.S. Treasury Secretary Timothy Geithner, who was in Germany to meet with EU leaders ahead of Friday's summit, said the European Central Bank was playing a positive role in the euro zone debt crisis, but he played down talk that the U.S. Federal Reserve could boost funding of the International Monetary Fund for the crisis.
Uncertainty over whether policy makers will be able to contain the euro zone debt crisis halted a six-session run for global stocks with the MSCI world equity index down 0.6 percent. U.S. and European shares fell.
The Dow Jones industrial average <.DJI> added 45.79 points, or 0.38 percent, to 12,143.62. The Standard & Poor's 500 Index <.SPX> was off 0.09 points, or 0.01 percent, to 1,256.99. The Nasdaq Composite Index <.IXIC> slipped 10.75 points, or 0.40 percent, to 2,645.01.
Equities will continue to remain strongly correlated with headlines out of Europe, though the market has already priced in a great deal of potential bad news, said Leo Grohowski, chief investment officer at BNY Mellon Wealth Management.
Speaking at the Reuters 2012 Investment Outlook Summit, Grohowski forecast below-average returns for the S&P 500 over the next three years, but said the current environment would likely turn out to be a better entry point than exit point for investors.
European stocks as measured by the FTSEurofirst 300 ended down 0.4 percent in a thinly traded session.
The euro slipped against the dollar for the third day in a row in choppy trade. The euro was down 0.2 percent at $1.3378, with the session low at $1.3332, according to Reuters data.
The state of markets is that they are still ripe for consolidation especially until Friday's EU summit, said Alexander Chepurko, foreign exchange analyst at Forex Club.
There is simply too much European drama going about and now S&P has joined the political debate by offering its opinion right on the eve of the summit.
Separately, the EU said the euro zone's economy grew an anemic 0.2 percent in the third quarter, giving grounds for the European Central Bank to cut interest rates at its policy meeting on Thursday.
A Reuters survey of 73 analysts showed a 60 percent chance the ECB will cut rates by 25 basis points to a record low of 1.0 percent on Thursday.
The ECB is also likely to offer ultra-long liquidity operations to support banks, while leaving the door open to further measures to fight Europe's debt crisis if governments agree fiscal reforms, the survey showed.
(Additional reporting by Atul Prakash in London, Rodrigo Campos and Nick Olivari in New York, Editing by Chizu Nomiyama)