The euro fell to a near 17-month low and world stocks fell on Friday in anticipation that Standard & Poor's would downgrade the ratings of several euro zone countries, including France -- action that S&P took after U.S. markets closed.
Talk of the impending downgrades permeated markets throughout the day based on news reports quoting sources.
S&P downgraded its debt ratings on nine euro zone countries, including Italy, Spain, Portugal and Austria, as well as France. Germany's rating was left unchanged.
The downgrades were the latest blow to the euro zone, which has been mired in a debt crisis and appears headed for recession.
Still, stocks ended well off the day's lows, with markets already having expected downgrades by S&P, which in early December said it was reviewing its ratings on 15 euro zone countries.
I think market participants may now be factoring in that longer-term risk factor in the equation - that Europe will take a while to sort itself out, that the economic recession in the region is now there for some time and possibly for longer than consensus estimates, said Natalie Trunow, chief investment officer of equities at Calvert Investment Management in Bethesda, Maryland, which has about $13 billion in assets.
The biggest reaction was in foreign exchange, with the euro tumbling to a low of $1.2623 against the dollar, its weakest level since late August 2010. It last traded at $1.26830, down 1.1 percent on the day. The currency posted its third straight weekly loss, based on EBS data.
The euro also fell to an 11-year low versus the yen.
Analysts said another hit to the euro was the breakdown in talks between Greece and its creditor banks to cut the country's debt.
World stocks as measured by the MSCI World Equity Index <.MIWD00000PUS> finished down 0.5 percent after earlier falling more than 1 percent. Major U.S. indexes were down about 0.5 percent, paring losses of as much as 1 percent earlier.
The Dow Jones industrial average <.DJI> was down 48.96 points, or 0.39 percent, at 12,422.06. The Standard & Poor's 500 Index <.SPX> was down 6.41 points, or 0.49 percent, at 1,289.09. The Nasdaq Composite Index <.IXIC> was down 14.03 points, or 0.51 percent, at 2,710.67.
Banks led the decline, pressured by news reports of the expected downgrades by S&P and by lacklustre earnings by JPMorgan Chase & Co
The pan-European FTSEurofirst 300 <.FTEU3> index of top shares dipped 0.1 percent to close at 1,017.84 points.
It isn't like we have not seen this coming, and I think this is reflected in the way equity markets have moved lower, but not to the degree that we would have seen a number of months ago, said Will Hedden, sales trader at IG markets.
ITALIAN DEBT SALE OVERSHADOWED
The S&P downgrades overshadowed a lacklustre sale of Italian debt.
Underpinned by a flood of European Central Bank cheap, three-year loans to banks, Italy's three-year debt costs fell below 5 percent for the first time since September in an auction, spurring hopes it would make it through a stretch of looming refinancing.
But demand was weaker than a sale on Thursday by Spain, the other major euro zone economy on the front line of the crisis.
U.S. bond prices rose as investors sought perceived safe-haven assets. The benchmark 10-year U.S. Treasury note was up 18/32, with the yield at 1.8636 percent.
The European situation is far from settled and has the potential to disrupt things, and that disruption means people will buy Treasuries, said Jim Kochan, chief fixed-income strategist at Wells Fargo Advantage Funds, with $219.9 billion in assets under management, in Menomonee Falls, Wisconsin.
German 10-year bond futures rose to a record while the risk premium investors charge on French, Spanish and Belgian debt widened in reaction.
But the widening of the French 10-year debt over German was debt in the range of 10 basis points, a minimal spike considering that the reaction could have been sharper.
A London trader said he did not believe that a flood of cash moving into the debt was keeping the spreads to a minimum, reflecting instead that there had not been a massive flight from the French bonds.
DOWNGRADE TALK ALSO WEIGHS ON GOLD, OIL DOWN
Gold fell as the dollar surged against the euro, sparked by the downgrade reports.
Spot gold was down 1 percent at $1,633.90 an ounce.
The dollar seems to be the main go-to safe-haven play at the moment, said David Meger, director of metals trading at futures brokerage Vision Financial Markets.
In the oil market, Brent crude oil futures fell for the third straight day. In London, ICE Brent for February delivery settled at $110.44 a barrel, down 82 cents, or 0.74 percent. On the New York Mercantile Exchange, February crude settled at $98.70 a barrel, dropping 40 cents, or 0.40 percent.
(Reporting by Caroline Valetkevitch, addtional reporting by Ellen Freilich, Gertrude Chavez-Dreyfuss, Carrick Mollencamp and Frank Tang in New York and John Stonestreet in London; Editing by Editing by Leslie Adler)