Italy bond yields soar; euro zone troubles deepen

Italian government bond yields soared to near 15-year highs, putting the euro zone's third largest economy front and center of the region's debt crisis, despite scrambling efforts by policymakers to stem the growing contagion.

Italy, the world's eighth largest economy, overtook Greece as the prime threat to the stability of the 17-country single currency zone, as finance ministers met to try to find ways of building a firewall around the two-year-old crisis.

Italian 10-year bond yields rose to their highest since 1997 -- approaching levels regarded as unsustainable -- with political turmoil in Rome threatening to drag a fourth European economy after Greece, Ireland and Portugal into the debt mire.

Jean-Claude Juncker, the chairman of Eurogroup finance ministers, said the European Central Bank would take part in monitoring Italy's promised economic reforms along with the European Commission and the International Monetary Fund, effectively putting the country under full surveillance.

Greece's outgoing socialist prime minister and conservative opposition leader rushed to put in place an interim national unity government for just long enough to save their country from imminent default by implementing a new bailout program.

France announced new austerity measures designed to preserve its wobbly AAA credit rating, without which the euro zone might no longer be able to bail out its weakest members.

In Brussels, euro zone finance ministers agreed a detailed mandate to scale up the currency zone's rescue fund by the end of November to shield vulnerable but solvent economies such as Italy's and Spain's from a possible Greek default.

In Rome, Prime Minister Silvio Berlusconi defied huge pressure to resign as he struggled to hold a crumbling center-right coalition together after being forced to accept intrusive IMF surveillance of his economic reforms.

Political sources said leaders of Berlusconi's PDL party had urged him to resign late on Sunday but he was resisting.

Juncker stopped short of calling for a national unity government in Italy, saying it wasn't under EU/IMF protection.

"What we are expecting from Italy is that Italy will implement all the measures which have been announced in Silvio Berlusconi's letter," he said after the finance ministers' meeting, referring to a letter sent last month that set out plans for pensions reform and deregulation.

Stocks fell worldwide on the uncertainty, but Italian shares ended higher, partly on hopes that Berlusconi could soon be gone, traders said.

A cabinet minister said Italy would face early elections if party rebels stripped Berlusconi of his majority in a crunch vote on public finances in parliament on Tuesday.

"If we have the majority we'll carry on, otherwise there'll be elections," Gianfranco Rotondi, a minister without portfolio, said after meeting Berlusconi at his Milan home.

Former European Central Bank vice-president Lucas Papademos was on his way to Athens, tipped to head a transitional Greek cabinet charged with pushing a 130 billion-euro (USD 170 billion) bailout plan through parliament to secure a crucial 8 billion-euro aid tranche before early general elections in February.

A Greek government spokesman said talks on finding a new prime minister were continuing in a good spirit, indicating no decision had been reached. The Greek cabinet will convene at 5 a.m. ET on Tuesday to discuss developments.

A senior opposition source said Finance Minister Evangelos Venizelos and his top economic team would stay for continuity.

Whoever leads the temporary Greek administration will face a monumental task in restoring order to a country of 11 million whose chaotic economy and politics are shaking international confidence in the entire euro project.

Asian shares lower, euro capped ahead of Europe

Asian stocks fell on Thursday, as growing investor caution about taking risks ahead of a key European leaders' summit at the weekend weighed on riskier assets across the board and supported safe-haven government bonds.

The euro struggled to make much headway, having pared gains on Thursday on fresh reports suggesting Europe remains a long way from resolving its debt woes. The single currency was up 0.1 percent against the dollar at USD 1.3770.

Plans to tackle the euro zone debt crisis have stalled, with Paris and Berlin at odds over how to increase the firepower of the region's bailout fund, French President Nicolas Sarkozy said on Wednesday, heightening concerns about how much progress could be made at a summit of European leaders on Sunday.

Investors are looking for more details from the meeting of plans to contain the euro zone sovereign debt crisis, particularly beefing up the rescue fund, a vehicle to guarantee national governments' sovereign debt issuance, although many believe a rapid solution is unlikely.

The meeting is also expected to agree on a plan to recapitalize European banks, but a report in the Financial Times said on Thursday that the plan to strengthen Europe's banking system is set to fall short of market expectations.

MSCI's broadest index of Asia Pacific shares outside Japan fell 0.6 percent, with the materials sector leading the decline, falling 1.5 percent.

Australian shares fell 1.2 percent on Thursday as miners sank after copper and gold prices fell, while Japan's Nikkei stock average opened down 0.4 percent.

The MSCI world stocks index was down 0.3 percent at 297.88, while US stocks ended lower on Wednesday as sentiment was also undermined by the Federal Reserve's Beige Book report, which suggested the outlook for the US economy grew dimmer in September.

Oil edged up in early Asia on Thursday, after falling the day before on concerns about growth. Brent crude futures were up 0.4 percent to USD 108.88 a barrel, while US crude futures edged 0.2 percent higher at USD 86.30 a barrel.

In Asian credit markets, spreads on the iTraxx Asia ex-Japan investment grade index, a gauge for whether investor risk appetite is returning, widened a tad by 1 basis point.

US Treasury prices rose modestly on Wednesday, with benchmark 10-year Treasury notes trading up 4/32 in price to yield 2.16 percent, down from 2.18 percent late Tuesday.

Gold fell for a third consecutive session on Wednesday, moving once again in tandem with riskier assets, as jittery investors sold on a lack of progress over euro zone debt talks and an uncertain US economic outlook. Spot gold was steady at USD 1,641.49 an ounce.

US rejects plan to strengthen IMF in euro zone crisis

Proposals to double the size of the IMF as part of a broader international response to Europe's debt crisis ran into resistance from the United States and others, burying the idea for now and putting the onus firmly back on Europe.

The outlines of the plan, that had the backing of several developing economies, emerged as G20 finance ministers and central bankers met in Paris to discuss a world economy under threat from European nations mired in debt.

A second day of talks on Saturday may produce more robust language on the urgency of tackling the euro zone debt crisis but little of substance is likely to be inked in with an EU summit in nine day's time the make-or-break moment.

A communique and round of closing news conferences are expected around 11 a.m. EDT with other decisions set up for a G20 leaders' summit in Cannes on November 3/4.

One G20 source said emerging market policymakers backed injecting some USD 350 billion into the International Monetary Fund.

US Treasury Secretary Timothy Geithner and his Canadian and Australian counterparts poured cold water on the idea. The IMF's dominant shareholders, including the United States, Japan, Germany and China, are content that the fund's USD 380 billion worth of resources is enough.

"They (the IMF) have very substantial resources that are uncommitted," Geithner said.

German Finance Minister Wolfgang Schaeuble agreed the euro zone debt crisis was for Europe to solve, and expressed confidence that EU leaders would produce a plan at the October 23 summit that would be convincing for financial markets.

The United States is among countries keen to keep pressure on the Europeans to act more decisively to end the two-year-old debt crisis that began in Greece but has since spread to Ireland and Portugal and is lapping at Spain and Italy.

Canadian Finance Minister Jim Flaherty also said the G20 should keep up pressure on the euro zone on its "arduous" journey toward a solution and not focus on IMF resources.

If minds needed concentrating further, Standard and Poor's cut Spain's long-term credit rating, citing the country's high unemployment, tightening credit and high private sector debt, highlighting the risk of a much larger economy than Greece coming under threat.

French and German officials are trying to put flesh on the bones of a crisis resolution plan in time for the European Union summit.

Fears about the damage a default by Greece -- and possibly others -- could inflict on the financial system have driven a confidence-sapping bout of market volatility since late July, with global stocks falling 17 percent from their 2011 high in May.

Unlike in 2009 when the G20 launched coordinated stimulus to pull the world out of crisis, the rest of the world is chafing at Europe's slow response while Washington and Beijing are sparring over the yuan currency.

The Franco-German crisis plan is likely to ask banks to accept bigger losses on their Greek debt than the 21 percent spelled out in a July plan for a second bailout of Athens, which now looks insufficient.

"It will be more, that's more or less certain," French Finance Minister Francois Baroin said.

It should also lay out a system for recapitalizing banks and plans to leverage the euro zone's 440 billion euros European Financial Stability Facility to give it more punch.

Schaeuble said European banks should be helped, if necessary, with state means to strengthen their capital.

Whilst the EFSF has the resources to cope with bailouts for Greece, Portugal and Ireland, it would be overwhelmed by the need to rescue a bigger economy such as Italy or Spain.

The most effective method would be to turn the EFSF into a bank so it could draw on European Central Bank resources. Both Germany and the ECB are opposed to that. Attention has turned to the idea of making the fund more like an insurer.

G20 sources said most BRICS economies were in favor of bolstering the IMF's capital as a crisis-fighting tool.

"We have said this before and have conveyed this again, that if emerging economies and the BRICS are called upon to contribute, we can do it via the International Monetary Fund," one of the sources said. "India is open to it, China and Brazil are also okay with the idea."

Another G20 source said the IMF would present a plan which had broad support to its executive board to make short-term credit lines available to fundamentally healthy countries hit by liquidity crises. It could aid euro zone countries hit by the current crisis of confidence in the bloc's sovereign debt.

Any real progress on bigger goals such as setting parameters to measure global imbalances and reining in speculative capital flows is unlikely to come before a November 3-4 summit in Cannes, where France passes the G20 baton to Mexico.

A separate G20 source said after preparatory talks late on Thursday that China would commit to boost its consumption through a five-year plan, via households and companies as well as infrastructure.

The G20 countries make up 85 percent of global output.

An April G20 meeting placed seven large economies under review -- the debt-burdened United States, export driven China and the economies of France, Britain, Germany, Japan and India. Officials have said privately the aim was to get Beijing to discuss the yuan, and China's cooperation is essential to the success of the process.

A G20 official said China would not commit to a quick liberalization of its yuan currency to help rebalance global growth, but would offer to use expansionary fiscal policy to fuel domestic demand.

"No, they were pretty firm on that -- there will be no progress," the official said.

EU works on banks, Obama urges swift action

European Union moves to shore up ailing banks moved into higher gear on Thursday as US President Barack Obama urged European leaders to act faster to tackle a sovereign debt crisis that threatens global economic recovery.

The EU's executive arm said it would present a plan for member states to coordinate a recapitalisation of their banks, as regulators met in London to reassess the capital buffers of stressed lenders that received a clean bill of health in July.

The European Central Bank threw a lifeline to commercial banks by turning up its liquidity pumps to provide longer-term cheap money for the growing number of European lenders which have seen wholesale funding dry up as market confidence ebbs.

The moves came amid fears that Greece, the most heavily indebted euro zone state, may default within months, setting off a chain reaction of sovereign downgrades and bank failures.

"We are now proposing member states to have a coordinated action to recapitalise banks and so to get rid of toxic assets they may have," European Commission President Jose Manuel Barroso said in a television interview relayed on YouTube.

It was the most explicit statement yet from a top European official on joint action to help restore confidence in a banking sector that is increasingly being shunned by investors as the euro zone debt crisis deepens.

However, a senior EU official told Reuters there would be no common European mechanism to deal with toxic assets, and no joint "bad bank" for Europe.

In Washington, Obama told a news conference that uncertainty about the euro zone crisis was hitting global markets and posed the biggest headwind to the US economy.

Ratcheting up pressure on European leaders, he said he hoped they would have a concrete plan in time for a Nov. 3-4 Group of 20 summit to overcome the debt crisis by creating enough "firepower" to help weaker member states.

US Treasury Secretary Timothy Geithner told Congress in prepared testimony: "The critical imperative is to ensure that the governments and the financial systems under pressure have access to a more powerful financial backstop."

In the first case of a bank felled by the crisis, Franco-Belgian municipal lender Dexia's board will vote on a break-up plan on Saturday as the French and Belgian governments argue over how to split the cost to the taxpayer.

Barroso would not speculate on how much money would be needed for recapitalisation across the 27-nation bloc but his comments helped push European shares up 2.4 percent on the day as investors welcoming signs of action.

The ECB disappointed some investors by leaving interest rates unchanged at 1.5 percent, on a split decision, despite signs of a sharp slowdown in the European economy. But it compensated with a raft of measures to boost liquidity.

ECB President Jean-Claude Trichet announced after chairing his final monetary policy meeting before retiring that the ECB will provide unlimited one-year funding in two operations and revive its policy of buying covered bonds for up to 40 billion euros.

German Chancellor Angela Merkel said Europe should not hesitate to recapitalise its banks if this prevents greater economic damage, and leaders would take very seriously expert advice that the time was ripe for such a step.

Jean-Claude Juncker, chairman of euro zone finance ministers, said banks in need of capital should turn first to the markets, then to national governments and as a last resort to the euro zone's rescue fund.

Some officials fear other lenders could suffer a similar fate to Dexia, even though they passed the European Banking Authority's (EBA) July stress test of 91 banks in the EU.

Those tests concluded that only eight banks failed and that they needed a collective 2.5 billion euros ($3.3 billion) -- a fraction of the up to 200 billion euros the International Monetary Fund believes EU banks require.

The EBA, which set the criteria for the tests carried out by national regulators, held the second day of a board meeting to review banks' capital needs based on the same data which formed the basis of those tests.

If the banks were forced to mark sovereign bonds holdings to current market prices, 18 would fail with a total capital hole of 40 billion euros, according to a Reuters Breakingviews stress test calculator.

EU Competition Commissioner Joaquin Almunia said there was a need to reassess bank assets, especially sovereign debt, to promote recapitalisation, but public money should be used only as a last resort and in line with the bloc's state aid rules.

The EBA is preparing the ground by determining which lenders should be included in any coordinated recapitalisation that its members would oversee. The European Commission has no power to impose a recapitalisation plan on EU states.

Markets and industry officials say the key missing piece is whether enough money can be found fast enough to fund a recapitalisation plan and stop contagion from Greece or Dexia.

"The euro zone knows what it needs to do and should just get on with it," a UK banking industry official said.

The EBA, made up of regulators and central bankers from EU member states, said it was asked by the European Systemic Risk Board last month to "coordinate efforts to strengthen bank capital".

It is under pressure after its chairman, Andrea Enria, admitted on Tuesday that this year's stress test, which Dexia passed with flying colours, failed to reassure investors.

Some banks have come under heavy criticism for not updating investors clearly on the value of their government debt holdings and bumping up capital buffers to cover markdowns.

Equity funds post worst quarter in nearly 3 years

India's diversified stock funds posted their worst quarterly performance in nearly three years, as rising interest rates, slowing economic growth and global debt worries led to a fall in key stock indices.

Such funds lost an average 9.84 percent in the September quarter, their weakest quarterly performance since the October-December 2008 period when they fell over 20 percent, data from fund tracker Lipper, a Thomson Reuters company, showed.

The fall mirrored the drop in the BSE Sensex which declined 12.7 percent during the same period, the index's biggest fall since shedding 25 percent in the December 2008 quarter.

"Capital goods and industrials were the biggest contributors to the poor performance of equity funds," said Dhruva Raj Chatterji, senior research analyst, Morningstar India.

"Large-cap equity funds fell more than their mid-cap cousins during the quarter."

Losses in the capital goods sector, which fell 22.7 percent in the quarter, hammered unit values as equity diversified funds had an over 20 percent exposure to this sector as of end-August, data from Morningstar India showed.

Metal stocks also contributed to the fall, as reflected in the BSE metal index which fell 27 percent.

Mutual funds were also hit by investments in financial services stocks, another favourite theme of managers with an over 20 percent allocation, as the banking index fell 15.4 percent on worries about slowing credit growth amid a rising interest rate environment.

Data showed that fund managers slowly increased their combined exposure to small- and mid-cap stocks in recent months to 36.5 percent of assets by end-August, their highest level since January 2011.

The move, however, did not help funds, as the BSE mid-cap index fell 10.6 percent and the small-cap index slumped 15.6 percent in the September quarter.

Among sectoral equity schemes, funds that invest in the IT sector fell 13.3 percent, tracking the 13.5 percent fall in the BSE IT index, while banking funds lost an average 15.3 percent in the quarter.

Gold exchange traded funds (ETFs) staged an impressive performance in the quarter, rewarding investors with an over 17 percent average return as global debt woes boosted the yellow metal's appeal, sending prices higher.

Diversified equity funds fell 1.45 percent on average in September, nearly in line with the 30-share BSE index's fall of 1.34 percent in the month, data showed.

Funds' investments in capital goods and metals proved to be a drag on unit values, as the sectoral indices fell 10.82 percent and 9.1 percent, respectively, in September.

Gold exchange traded funds (ETFs), which were star performers in August, lost 3.4 percent in September as gold prices eased.

On the continuation charts, India's gold futures ended the month at 25,989 rupees per 10 grams, down 4.4 percent.

"Fundamentally, nothing has changed on gold ... prices could go much higher," said Chirag Mehta, fund manager - commodities at Quantum Asset Management.

Among debt schemes, funds that invest in government securities returned 0.26 percent in the month, Lipper data showed.

Europe hastens to build up debt crisis defenses

European policymakers are quickening their preparations to cope with an escalation of the region's debt crisis as talk of a possible Greek default gained pace on Friday.

Finance chiefs from around the world have turned up the heat on Europe to do more to prevent Greece's debt crisis from infecting other euro zone countries and the world economy.

Concern now appeared to be turning towards safeguarding the banking system more than rescuing Greece, as international lenders were increasingly losing patience with Athens consistently missing fiscal and reform targets.

"They have six weeks to resolve this crisis," said British finance minister George Osborne, speaking on the sidelines of semi-annual policy discussions in Washington.

Euro zone leaders need to have the situation under control by the time leaders of the Group of 20 economies meet in France in November, he said.

World stock markets, which had plunged to a 14-month low on fears about the scale of the euro zone crisis, steadied after European Central Bank officials said they would use more firepower to help the banking system through the crisis.

Pressure is growing on European governments for a recapitalization of the region's banks to strengthen them in the event of a Greek default.

At the same time, European policy-makers seemed to be warming to the idea of giving more muscle to their bailout fund which would be tested in the event of a Greek debt default.

Finance Minister Evangelos Venizelos was quoted by two newspapers as saying an orderly default with a 50 percent haircut for bondholders was one way to resolve the heavily indebted euro zone nation's cash crunch.

Greece is in tense talks with the International Monetary Fund and European authorities, known as the troika, to secure a new 8 billion-euro installment of its rescue package to avoid bankruptcy in October in return for austerity measures.

The Greek finance minister is due to meet the head of the IMF on Sunday.

Negotiators have expressed frustration at what they say is Greece's slow pace. "The troika officials said they were going over again measures they had agreed to months before. They said they had a sense of deja vu," a source close to the inspectors said on condition of anonymity.

After October's loan payment, which is widely expected to be made, the next instalment is due in December.

European Central Bank President Jean-Claude Trichet urged authorities to take decisive action, saying risks to the financial system had "increased considerably."

Lawrence Summers, former US Treasury secretary, gave a sombre of assessment of the dangers facing the world economy, including the US economy slowing to almost a standstill.

"This is the 20th annual meeting (of the IMF and World Bank) I've been privileged to attend. There has not been a prior meeting at which matters have had more gravity and at which I have been more concerned about the future of the global economy," Summers told a discussion panel.

As European policymakers looked to piece together a bolder crisis-fighting strategy, investors took some relief as three officials said the ECB could revive its one-year liquidity lines to shore up banks.

"I think it might be advisable to think about reintroducing this approach," ECB governing council member Ewald Nowotny said.

The IMF, which has been pressing aggressively for a recapitalization of Europe's banks, reckons the debt crisis has increased their risk exposure by 300 billion euros.

In a sign Europe was coming to terms with the idea of a recapitalization, France's top market regulator said 15 to 20 banks needed extra capital, although no French ones "at this stage."

The growing talk of a Greek default met with stiff opposition from Germany's Chancellor Angela Merkel. She told a meeting of her political party members that was not an option for her because it might trigger a domino effect in other struggling economies. "The damage would be impossible to predict," Merkel warned.

Politicians in northern Europe, especially in Germany, have opposed dedicating more money to fight a crisis that they see as caused by the profligacy of countries such as Greece.

ECB governing council member Klaas Knot told a Dutch daily a Greek default could no longer be ruled out, the first ECB policymaker to speak openly of the prospect.

That warning was echoed by the IMF's top official in Europe, Antonio Borges: "If the Greeks do what they have to do there will be no default. But on the other hand if they hesitate, procrastinate, find it impossible etc., then it is very hard to avoid it."

G20 finance ministers and central bankers had pledged on Thursday to "take all necessary actions to preserve the stability of the banking system and financial markets as required," a statement that failed to placate investors.

High-flying gold crashes in record $100 freefall

Gold prices slumped more than USD 100 an ounce on Friday, the biggest fall on record in dollar terms, as traders sold to cover losses, while global stocks edged up on expectations the European Central Bank will take new measures to contain the euro zone debt crisis.

Trading was volatile, capping one of the most tumultuous weeks on record for world markets as fear of a Greek default and a gloomy Federal Reserve prognosis for the US economy sparked a sell-off in stocks and commodities and drove investors to the safe-haven US dollar and Treasuries.

A pledge by G20 policy makers that they will calm the global financial system failed to appease investors, who are concerned that authorities are unable to respond effectively to the mounting euro zone debt crisis and sluggish growth in major world economies.

Gold slumped more than 6 percent at one point -- its biggest drop since the financial crisis in 2008 -- to hit its lowest since early August as a slide turned into a free-fall, with weeks of volatility and talk of hedge fund liquidation wrecking its safe-haven status.

"The bull case for gold is on pause for the near term," said Adam Klopfenstein, senior market strategist for precious metals at MF Global in Chicago.

"In the near-term, the flight-to-quality interest in owning gold is also out of the window as people are not interested in buying it even in the face of fears in the economy. Until it stabilizes, I'm staying out of this market."

Spot gold was last at USD 1,649 an ounce, after falling to a session low under USD 1,628. At USD 127 an ounce, the intraday move was the biggest on record in dollar terms.

US stocks ended higher after seesawing between gains and losses, stopping the bleeding after a disastrous four days of selling marred by severe anxiety.

Comments from European Central Bank Governing Council member Ewald Nowotny, who said it might be advisable for the central bank to add more liquidity to European banks helped lift sentiment.

The Dow Jones industrial average ended up 37.65 points, or 0.35 percent, at 10,771.48. The Standard & Poor's 500 Index was up 6.87 points, or 0.61 percent, at 1,136.43. The Nasdaq Composite Index was up 27.56 points, or 1.12 percent, at 2,483.23.

Global stocks as measured by the MSCI All-Country index were up 0.2 percent, after hitting their lowest level since July 2010 at 274.20.

The index is now in bear market territory -- defined as a fall of 20 percent or more from the peak -- having tumbled more than 22 percent from its 2011 high in May.

"Financial markets are sick and tired of the authorities in Europe and in the US twiddling their thumbs and not doing substantive things to solve this crisis of the global economy," said Barton Biggs, managing partner at New York-based Traxis Partners.

The FTSEurofirst 300 index ended up 0.8 percent. Emerging markets stocks slid 1.6 percent.

Liquidity comments from ECB officials and speculation the central bank may cut rates helped sentiment initially, but uncertainty about Greece remained.

Greece denied reports that one option in its debt crisis would be an orderly default with a 50 percent haircut, while Deutsche Bank warned that European banks' write-downs on Greek bonds could exceed 25 percent.

Metals prices plunged across the board. Silver prices posted their biggest drop since 2006. Spot silver was down 15 percent and trading below USD 35.76 an ounce after hitting a session low of $29.77.

Copper hit USD 7,115.75, its lowest since August 2010. It was its sharpest weekly decline in nearly three years for the economically sensitive red metal.

US crude fell 66 cents to settle at USD 79.85 a barrel. London Brent crude fell USD 1.52 to settle at USD 103.97.

The euro rose 0.4 percent to USD 1.3515, rebounding from an eight-month low. The dollar rose 0.5 percent to 76.66 yen and was on track for its best month since May 2010 against a basket of currencies.

US Treasuries prices slipped after a huge rally this week.

Benchmark US 10-year notes were down 1-2/32 in price, with yields rising to 1.84 percent. Prices of 30-year bonds were down 2-1/32, yielding 2.90 percent.

Moody's cuts eight Greek bank ratings by 2 notches

Moody's Investors Service on Friday downgraded the ratings of eight Greek banks by two notches each citing a struggling domestic economy and declining deposits among reasons for the move, which was expected by markets.

Moody's said the outlooks for all the ratings remained negative. The downgrade concluded a review begun on July 25.

The agency cut National Bank of Greece SA (NBG), EFG Eurobank Ergasias SA (Eurobank), Alpha Bank AE (Alpha), Piraeus Bank SA (Piraeus), Agricultural Bank of Greece (ATE) and Attica Bank SA downgraded to Caa2 from B3.

Emporiki Bank of Greece (Emporiki) and General Bank of Greece (Geniki) were downgraded to B3 from B1.

S&P cuts ratings on Italy by one notch

Standard and Poor's cut its unsolicited ratings on Italy by one notch on Monday, warning of a deteriorating growth outlook and damaging political uncertainty, in a move that took markets by surprise and added to pressure on the debt-stressed euro zone.

S&P's downgraded its unsolicited ratings on Italy to A/A-1 from A+/A-1+ and kept its outlook on negative, sending the euro more than half a cent lower against the dollar.

The agency, which put Italy on review for downgrade in May, said that the outlook for growth was worsening and there was little sign that Prime Minister Silvio Berlusconi's fractious center-right government could respond effectively.

Under mounting pressure to cut its 1.9 trillion euro debt pile, the government pushed a 59.8 billion euro austerity plan through parliament last week, pledging to balance the budget by 2013.

But there has been little confidence that the much-revised package of tax hikes and spending cuts, agreed only after repeated chopping and changing, will do anything to address Italy's underlying problem of persistent stagnant growth.

"We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve," S&P's said in a statement.

"Furthermore, what we view as the Italian government's tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy's economic challenges," it said.

Berlusconi's coalition has been plagued by infighting and policy disagreements and the prime minister himself has been battling a widening prostitution scandal which has distracted the government and badly damaged his personal credibility.

On Monday, Italian sources said the government was preparing to cut its growth forecast to 0.7 percent in 2011 from a previous forecast of 1.1 percent and cut the 2012 forecast to "1 percent or below."

Italy, the euro zone's third largest economy, has been dragged to the center of the debt crisis over the past three months as concern has grown over a debt burden equal to some 120 pecent of gross domestic product.

But the move from S&P came as a surprise as the market had thought Moody's was more likely to downgrade Italy first. Moody's last week said it would take another month to decide on its action.

"Was it anticipated tonight? No. But again is it really shocking given what yields have done?" said James Paulsen, Chief Investment Strategist, Wells Capital Management.

Only the European Central Bank, which has been buying Italian bonds to prop up the market, has kept Rome's borrowing costs from spiraling out of control, but yields have crept back up steadily since the ECB stepped into the market in August.

On Monday, yields on Italian 10 year bonds stood at 5.59 percent, within sight of the levels above 6 percent they reached just before the ECB intervention.

The intervention has caused growing strain within the central bank, causing Chief Economist Juergen Stark to announce his resignation and prompting open opposition from the Bundesbank.

The S&P downgrade, which came as Greece struggles to meet demands from lenders for yet more austerity measures, underlined the mounting seriousness of the euro zone crisis, which has seen global markets hammered.

"It's just more of the same negative news," said Stephen Roberts, a senior economist at Nomura in Sydney.

"It only adds to the contagion risk over Greece and has encouraged the flight to safety in markets here," he added, pointing to a sharp fall in the Australian dollar on the news. The Aussie dollar is influenced by expectations for commodity prices and so sensitive to the outlook for global demand.

S&P 500 futures also dropped 0.7 percent and early hopes for a bounce in Asian shares on Tuesday looked to be still-born now.

European stocks had already slid on Monday, while yields on Italian and Spanish bonds rose sharply on fears of a Greek default, compounded by the failure of EU finance ministers to agree new steps to resolve Europe's debt crisis at weekend talks.

International lenders told Greece on Monday it must shrink its public sector and improve tax collection to avoid running out of money within weeks as investors spooked by political setbacks in Europe dumped risky euro zone assets.