Negative reaction to Standard & Poor's downgrading of Italian debt was short-lived on financial markets on Tuesday, as European stocks pushed higher and the euro recovered from earlier losses.
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Markets remain on edge, however, about Greece's rickety finances, French banking stress and the next step by the U.S. Federal Reserve to try to ignite the U.S. economy.
World stocks as measured by MSCI were flat, but the pan-European FTSEurofirst 300 gained more than half a percent.
Traders said the relative strength in Europe was a reaction to falls in the previous session in markets marked by substantial volatility. The European index has lost more than 18 percent this year, mainly because of concern over euro zone finances.
The euro was flat after earlier falling on the news about Italy's downgrade. The ZEW Institute's German economic sentiment index fell, but had little impact on markets.
S&P downgraded its rating on Italy by one notch to A/A-1 and kept its outlook negative, surprising markets which have been speculating on a downgrade from rival Moody's but not S&P.
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It said the outlook for growth was worsening and there was little sign that Prime Minister Silvio Berlusconi's fractious centre-right government could respond effectively.
Under mounting pressure to cut its 1.9 trillion euro debt pile, Italy's government pushed a 59.8 billion euro austerity plan through parliament last week, pledging a balanced budget by 2013.
The downgrade underlined the poor state of euro zone finances and the fragility of attempts to fix it.
French banking stocks were among the worst performers in Europe after sources said that Bank of China had stopped foreign exchange forwards and swaps trading with several European banks due to the region's debt crisis.
Focus was also on Greece, which must shrink its public sector to avoid running out of money within weeks.
"Once again we do seem to be peering into the abyss here," said Cameron Peacock, analyst at IG Markets.
Core euro zone bonds were in demand as a safety play.
Other than euro zone worries, investors were bracing for a two-day meeting of the U.S. Federal Reserve, with an eye on what policymakers will do to ignite the faltering U.S. economy.
With one eye on the euro zone debt turmoil and another on a stubbornly high 9.1 percent U.S. unemployment rate, the Fed, is expected to begin shifting the composition of its balance sheet to weight it more heavily with longer-term securities.
"Operation Twist", as it has been dubbed, implies selling shorter-term debt or letting it mature and reinvesting in long-term bonds.
Ten-year U.S. Treasuries were flat.