Worries over Europe's banks and uncertain prospects for a hefty slate of euro zone debt sales this week kept markets volatile on Monday, with shares weaker and the single currency off lows but vulnerable to further losses.

German and U.S. data provided some relief but the euro zone's deep-seated problems kept investors wary, and a meeting between German Chancellor Angela Merkel and French President Nicolas Sarkozy later today will be closely watched for fresh developments.

The MSCI world equity index held onto a slight gain of just 0.1 percent despite a weaker session on Asian markets.

The FTSEurofirst 300 index of top European shares gave up early gains to be slightly weaker, falling 0.3 percent to 1010.40 points, having been hit last week by worries over bank capital raising plans following a deeply discounted rights issue by UniCredit.

Shares in Italy's biggest bank by assets fell again on Monday and trading in the rights to buy into the cash call were suspended, fuelling speculation other lenders may be deterred from using rights issues to plug capital shortfalls.

UniCredit's rights issue is a litmus test for banking stocks at a time when many European lenders are under pressure to shore up their capital buffers to withstand the spreading debt crisis.

The Italian bank's shares have lost 37 percent since it priced the 7.5 billion euro ($9.5 billion) capital increase, trading in the rights to buy into the cash call were suspended, fuelling speculation other lenders may be deterred from using rights issues to plug capital shortfalls.

The euro, which fell to a 16-month low in Asian trade of $1.2666, recovered to $1.2760 in volatile trade to stand up around 0.5 percent for the day as traders covered short positions.

"These are testing times for the currency and the scale of the recent decline seems to have caught some people by surprise," said Geoffrey Yu, currency strategist at UBS.

A busy week of government bond issues features triple-A issuers Germany, Netherlands and Austria, but most interest will be on sales by Spain and Italy on Thursday and Friday.

"The main focus is still the Italian and Spanish supply. While we've got that lurking over us I think the market is likely to still be a little bit wary," said Eric Wand, strategist at Lloyds Bank in London.

Italian 10-year paper yielded around 7.13 percent , firmly above the 7.0 percent level widely seen as unsustainable. Spanish equivalent bonds were at 5.74 percent.

 

ECONOMIC DATA BRIGHTENS

Friday's upbeat U.S. jobs data showed the jobless rate dropped to a near three-year low of 8.5 percent, and nonfarm payrolls increased by 200,000..

On Monday German exports jumped 2.5 percent in November, unexpectedly widening the trade surplus in a sign Europe's largest economy is still outpacing peers.

But rising debt tensions took the shine off both sets of figures, with a German magazine reporting on Saturday the International Monetary Fund was losing confidence in Greece's ability to clean up its public finances.

Also, an adviser to Germany's finance minister told a Greek newspaper a 50 percent writedown on Greek debt holdings - a key part of Greece's debt swap deal - was not enough to put the country's huge debt on a viable footing.

Underscoring the bearish view on the euro, currency speculators boosted short positions in the currency to record levels in the week ended Jan. 3, data from the Commodity Futures Trading Commission showed on Friday.

Investors also remained concerned about Hungary after Fitch downgraded the country's sovereign debt to 'junk' status with a negative outlook, suggesting the investment climate was not going to get any better.

A stronger dollar tends to weigh on commodities that are priced in the currency, and both precious and industrial metals lost ground.

Copper slipped around 0.5 percent to $7,540 a tonne, while gold was little changed at around $1,620 an ounce level.