European stocks and the euro steadied Tuesday after sharp selloffs on disappointment about last week's EU summit, but any gains could be short-lived due to lingering concerns over credit rating downgrades and the health of the banking sector.
Traders said there was a clear bias to sell the single currency on any bounce after the warnings of further imminent sovereign downgrades because EU leaders had failed to come up with decisive steps to tackle the region's debt crisis.
You worry about any gains that we are seeing, whether they're short term or not, because let's be honest, the European summit hasn't delivered on anything that's actually going to address the short term pressures in the market, said Joshua Raymond, market strategist at City Index.
The main European stock index, FTSEurofirst 300 <.FTEU3>, was up 0.5 percent after falling 1.9 percent on Monday.
Banking stocks could return to centre stage on equity markets after sources familiar with the matter told Reuters the German lender Commerzbank and the government have been in talks for several days over possible state aid.
While Commerzbank, 25 percent owned by Germany, wants to avoid state aid, it needs to find 5.3 billion euros ($7 billion) capital by mid-2012 to meet European Banking Authority capital rules.
Rating agency Moody's also put eight Spanish banks on review for possible downgrade including, Banco Sabadell , Bankia , Bankinter and CaixaBank .
The STOXX 600 Banks Index, which includes European companies that are involved in the banking sector was down around 1.5 percent from Monday's closing level.
The euro, which plumbed two-month lows in Asia of around $1.3160, was rescued by some short covering to steady at around $1.3170, little changed on Europe's previous session.
The last blow for the euro was the announcement from the ratings agencies last night, said Niels Christensen, currency strategist at Nordea in Copenhagen.
The core German debt market was also moving into positive territory with bunds broadly flat as the debt markets worried about the potential for ratings downgrades.
A survey of German analysts and investors was expected to show worsening sentiment in the euro zone with its index seen falling to -56.5 in December from November's reading of -55.2.
Italian and Spanish government bond yields were still rising as debt traders continued to fret over the risk of sovereign credit rating downgrades across the euro zone.
Italian 10-year government bond yields rose 17 basis points to 6.77 percent, widening the spread over safe-haven German bunds to 475 bps.
The main focus is expected to be on the EFSF's (European Financial Stability Facility) inaugural T-bill sale from its short-term funding program, expected to be up to 2 billion euros of 91-day bills.
The sale offers a chance for money market funds seeking high grade assets to diversify but interest is on how much of a yield pickup they will demand over German equivalents.
Elsewhere market activity is likely to be subdued ahead of the release of U.S. retail sales for November due out later and the outcome of the Federal Reserve's FOMC meeting, although no change in U.S. interest rates is expected.
(Editing by Anna Willard)