Dubai debt default concerns continued to send shockwaves across the world on Friday, with heightened risk aversion pushing global equities sharply lower and prompting investors to take refuge in government bonds.
U.S. stocks looked set to follow Europe and Asia lower in a shortened, post-Thanksgiving session.
The yen hit a 14-year high versus the dollar, which jumped against most other currencies as investors slashed risk exposure and carry trades. Japan signaled growing discomfort with the yen's surge and suggested it would be open to a Group of Seven joint statement on currencies to cool the rally.
Commodity prices extended previous session's steep losses, with crude oil slumping 5 percent and key base metals suffering heavy blows. Investor fears raised demand for lower risk government debt, with euro zone government bonds futures hitting their highest in eight months before paring gains.
The MSCI world equity index <.MIWD00000PUS> fell 1 percent to its lowest in 2-1/2 weeks, with the benchmark on track for a second consecutive weekly loss. The MSCI is still comfortably in black since the start of the year however, with the index holding gains of over 27 percent since January.
Investor appetite for risky assets fell sharply, with the VDAX-NEW volatility index <.V1XI> gaining 4.4 percent, a surge of 32 percent in three days. The higher the index, which is based on sell and buy options on Frankfurt's top-30 stocks <0#.GDAXI>, the lower the market's desire to take risk.
The fear in the markets is that this is only the first instance of a wave of governments with unsustainable debt to GDP ratios that will start reporting trouble paying off their debt, said Christian Blaabjerg, chief equity strategist at Saxo Bank.
Furthermore, fear is that this process will accelerate even further when interest rates are heading north during 2010 ... However, we expect short term that this is only a bump on the road, he added.
Dubai, part of the oil-exporting United Arab Emirates, said on Wednesday it would ask creditors of state-owned Dubai World and Nakheel to agree to a standstill on billions of dollars of debt as a first step toward restructuring.
The news shook markets recovering from the collapse of the U.S. housing bubble and contagion that threatened to rupture the global financial system last year.
Financial shares faced intense pressure, with DJ Stoxx European banking index <.SX7P> falling 8.5 percent in three sessions, because of potential exposure to any bad debt in the Gulf. European car companies, some of which are part-owned by sovereign wealth funds from the region, were also hit.
U.S. markets, closed on Thursday for Thanksgiving Day, were poised to track European and Asian losses. Futures for the S&P 500, Dow Jones and Nasdaq 100 fell 2.3 to 3 percent, while Japan's Nikkei <.N225> fell 3.2 percent.
U.S. markets will close early at 1pm local time (1800 GMT/1 p.m. EST).
It's absolute paranoia. This is the last thing the market needed in the run up to Christmas, said Manus Cranny, head of sales at MF Global.
It's not just the Dubai debt, investors are wondering what other black holes there are and what the ramifications are for global companies, he added.
YEN SURGES, BONDS CLIMB
Dubai debt concerns spurred flight to quality trades, with core euro zone government bond prices pushing higher, hoisting bond futures to their highest in almost eight months.
The dollar fell as far as 84.82 yen, its weakest since 1995 and ever closer to its record low of 79.75, before pulling back up to 86.43 yen. The dollar index <.DXY>, a measure of its value against six major currencies, rose 0.7 percent
A combination of systemic risk fears and thin market liquidity due to the U.S. holiday season has proven to be a combustible mix and several currencies or currency blocs are feeling the impact, UBS currency analysts wrote in a note.
The wider fallout has simply revealed how fragile both markets and risk appetite still are, they said.
European corporate credit defaults swap spreads were wider, reflecting the nervous mood. The investment-grade Markit iTraxx Europe was at 93.75 basis points, according to BGC Partners, 4.25 basis points wider versus late on Thursday.
In commodities, crude oil fell 5 percent to trade around $74 a barrel and copper and aluminum both hit two-week lows. But spot gold retreated further from record highs on a firmer dollar.
(Additional reporting by Jamie McGeever Simon Falush and Natsuko Waki in London and Blaise Robinson in Paris)