Global stocks fell to their lowest in more than a week on Thursday, knocked down by mounting concerns about a U.S. debt default which also kept the dollar subdued against the safe-haven Swiss franc and the yen.
European stocks fell for the fourth straight session, following their Asian counterparts, as sovereign debt risks weighed on sentiment and drove investors away from riskier assets to safer ones such as gold.
Stalemate in Washington over lifting the debt ceiling is increasing the possibility of a U.S. credit rating downgrade and has raised the prospect that the government of the world's leading economy will run out of money to pay its bills.
The problem is that the whole thing has been a wake-up call for the market, a real black swan: we're now starting to price in a default risk for the world's biggest economy, which was inconceivable just a few months back, said David Thebault, head of quantitative sales trading at Paris-based broker Global Equities.
European stocks <.FTEU3> were also hurt by a raft of mixed earnings reports which sparked worries about company profits.
Banks were among the top losers, led by Credit Suisse
World shares as measured by MSCI <.MIWD00000PUS> were down 0.3 percent while the MSCI index of Asia Pacific stocks outside Japan <.MIAPJ0000PUS> was down 0.85 percent, with technology, commodity-related and consumer shares the biggest drags.
The safe-haven yen was the main beneficiary of poor risk sentiment, making gains against both the euro and the dollar.
The greenback also hovered near a record low against the Swiss franc with investors increasingly downbeat about its prospects on concerns that deficit reduction proposals being discussed in Washington may fall short of the budget cuts necessary to avert a U.S. debt downgrade.
The deadlock in Washington has not pulled traders' attention away completely from the euro zone, where Italian and Spanish bond yields keep rising relative to German bonds and calm after last week's second bailout for Greece has evaporated.
At the moment it's all about the U.S. debt ceiling, said David Bloom, global head of FX research at HSBC. But if you ask which of these debt crises you would prefer, the answer is neither.
The 10-year Spanish/German bond yield spread widened 7 basis points on the day to 341 bps, while the equivalent Italian/German bond yield spread widened 10 basis points on the day to 322 basis points.
Attention is now on an Italian bond auction as investors try to gauge appetite for its high-yielding paper amid concerns the debt crisis could spread to the euro zone's No. 3 economy.
Japanese fund managers slashed their euro zone bond weighting to a record low and cut their U.S. bond allocations, while raising their Japanese bond weighting to a fresh all-time high, a Reuters poll showed.
U.S. 10-year Treasuries edged higher, stabilizing after falling overnight on a less-than-stellar auction of new five-year bonds. The 10-year yield was at 2.97 percent, a basis point below where it finished last night in New York.
With a ratings downgrade possible at any time, investors also kept a wary eye on U.S. credit default swap rates. The one-year CDS blew out to a record 85 basis points, pushing out the difference over five-year CDS to more than 20 basis points.
Gold has been a big winner as investors seek out hard assets to hedge against risks. Gold was steady at $1,617.80 an ounce after hitting an all-time high of $1,628 on Wednesday.
Brent crude was 0.7 percent higher at $118.20 a barrel.
(Additional reporting by Blaise Robinson and; Nia Williams; Editing by Catherine Evans)