Italy Downgrade, Greek Worry Dominate Europe’s Financial Markets

Standard & Poor’s downgrading of Italian debt hit the euro on Tuesday, although stock investors shrugged off the move to push European stocks higher.

Markets remain on edge about Greece’s rickety finances and French banking stress and world stocks as measured by MSCI were down slightly. But the pan-European FTSEurofirst 300 gained a third of a percent.

The European index has lost more than 18 percent this year, mainly because of concern over euro zone finances.

The euro lost around 0.2 percent against both the dollar and yen.

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.

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 [$81.7 billion] 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-end debt or letting it mature and reinvesting in long-term bonds.