A European summit deal to strengthen budget discipline in the euro zone failed to restore financial market confidence on Monday, forcing the European Central Bank to step in again gingerly.
The euro fell, stocks slid and borrowing costs for Italy and Spain rose as investors weighed the outcome of last week's summit that split the European Union, with Britain blocking treaty change and forcing euro zone countries to negotiate a fiscal accord outside the Union.
Friday's initial market rally petered out in less than 24 trading hours due to legal uncertainty surrounding the new pact and the absence of an unlimited financial backstop for the single currency.
French President Nicolas Sarkozy said the legal basis of a new accord to enforce debt and deficit rules in the 17-nation euro area with quasi-automatic sanctions and intrusive powers to reject national budgets would be worked out before Christmas.
Traders said the ECB intervened to buy short-term Italian debt after yields on Italian and Spanish debt spiked. But ECB sources told Reuters last week that purchases would remain limited with a maximum ceiling of 20 billion euros a week.
There is no prospect of a "big bazooka" to shock the markets.
Despite the central bank dabbling, Italian 5-year bond yields shot up above 7%, widely seen as a danger level while 10-year yields spiked above 6.8% and Spanish 10-year yields topped 6%.
Investors' appetite for short-term paper drove Italian one-year borrowing costs down just below 6% at an auction but yields remain uncomfortably high.
S&P has put 14 euro-zone governments on watch for a possible rating downgrade in the coming weeks, arguing that the deepening debt crisis and looming recession will increase their potential liabilities and reduce their ability to cope with them.
If some of the euro zone's AAA-rated members are downgraded, it would call into question the solidity of the euro zone's rescue fund, which would likely suffer a similar fate.
Interbank lending rates in the euro-zone fell to their lowest level since May after the ECB threw cash-starved banks a lifeline last week by offering unlimited three-year liquidity to counter a credit crunch.
