The euro surged to a lifetime high against the dollar on Wednesday, weighing on European shares as investors remained nervous over the health of the U.S. economy even with an expected interest rate cut there next week.
Wall Street was set for a weaker open while Tokyo stocks and the yen fell after Japan's embattled Prime Minister Shinzo Abe announced his resignation, fanning political uncertainty.
Money markets showed tentative signs of stabilization with overnight dollar interbank lending rates falling below the Fed's benchmark rate to their lowest since August 16.
Financial markets have been volatile in recent weeks as a credit squeeze stemming from fallout in U.S. subprime mortgages hit risky assets and pushed up interbank lending costs.
Expectations the Federal Reserve would cut interest rates next week by as much as 50 basis points gave some relief to risky assets, but this is negative for the dollar as it erodes the yield premium the currency offers.
Investors are also wary there could be more evidence the turmoil is hitting the real economy which would hurt corporate profits.
There is quite a lot of volatility... There is still a lot of uncertainty in the markets, said Philippe Gijsels, senior equities strategist at Fortis Bank in Brussels.
(A strong euro) is bad news for the European economy and also for European equities.
The FTSEurofirst 300 index was down 0.15 percent on the day while the MSCI main world equity index was up 0.1 percent on the day.
The MSCI index has recouped around half of the losses caused by a drop from the July record high to the August trough.
U.S. stock futures pointed to a weaker open on Wall Street. Earlier Tokyo stocks fell half a percent while the rest of Asia, measured by MSCI, was up 0.4 percent.
The euro rose as high as $1.3884, bringing its gains this year to almost 5 percent.
The iTraxx Crossover index, most widely watched indicator for European credit market sentiment, was steady at 345 bps, while emerging sovereign spreads tightened 7 bps.
The December Bund future was down 12 ticks.
IMPACT ON ECONOMY
Investors are keen to gauge how much the recent market turmoil would damage the world economy, which was enjoying its strongest growth in three decades earlier this year.
Analysts say the economy will soon feel the impact of elevated interbank lending rates. Banks are unwilling to lend to each other and keen to hang onto cash due to uncertainty over the valuation of complex products with exposure to subprimes or the beleaguered asset backed commercial paper market.
Day by day, the economic impact of elevated Libors grows. If and when this is apparent in the data, monetary policy easing in the UK and euro zone would likely ensue, HBOS Treasury Services said in a note to clients.
For now there were tentative signs that interbank lending rates have stabilized off recent peaks.
At the closely-watched fixing, London interbank offered rate fell below the fed funds target rate of 5.25 percent to their lowest since August 16, a day before the Fed cut its discount rate.
However, three-month euro rates only fell slightly on the day, with liquidity injection by the European Central Bank earlier having little effect. Earlier the ECB lent banks a record 75 billion euros in extra three-month funds.
Ratings agency Standard & Poor's said on Tuesday U.S. corporate default rates could accelerate from next year as the recent market turmoil has erased appetite for risky investments.
Elsewhere, U.S. light crude for October delivery held near the August record high above $78, while London Brent crude was down 0.4 percent on the day.
Gold found safe-haven bid and support from a weaker dollar, edging closer to the previous day's 16-month high.
(Additional reporting by Amanda Cooper)