GLOBAL MARKETS-Risk aversion sweeps markets as credit fears grow

LONDON, July 26 (Reuters) - A wave of risk aversion swept across financial markets on Thursday as investors worried about instability in world credit markets, leaving stocks sharply lower and driving demand for safe-haven government bonds.

Wall Street looked set for a poor start and European shares dropped more than 1 percent. Risky currency trades also looked subject to unwinding as the Japanese yen rose across the board.

Emerging sovereign bond spreads 11EMJ widened to 205 basis points over U.S. Treasuries, the highest in almost eight months.

The iTraxx Crossover index ITCRS5EA=GFI, the most widely watched indicator of European credit markets, blew out 35 basis points on the day to 400 basis points, its highest level this year.

"The market has started to see the risk of contagion growing," said RBC Capital Markets senior currency strategist Adam Cole.

"There's been a general assumption that the subprime issue was ring-fenced and that's been questionable in the past few days."

Problems in the U.S. subprime -- or risky -- mortgage market have been stalking investors for the past few weeks, rattling stocks, widening credit spreads and driving money into safe havens.

The fear is both that the financial system could come under threat and that borrowing costs for companies will rise, hurting earnings. News over the past 24 hours has exacerbated the worries.

Sydney-based Absolute Capital, a hedge fund half-owned by Dutch bank ABN AMRO AAH.AS, said it temporarily closed two funds because it was tough to offload investments in collateralised debt obligations (CDOs).

At the same time, adverse credit market conditions are spilling over into the financing of corporate deals, a backbone of many equity market gains this year.

Britain's Alliance Boots [AB.UL] postponed syndication of 5.05 billion pounds ($10.4 billion) of senior debt backing its leveraged buyout, a source told Reuters Loan Pricing Corp.

Similarly, DaimlerChrysler AG's DCXGn.DE $7.4 billion deal to spin off Chrysler hit a speed bump on Wednesday when bankers were forced to postpone a $12 billion syndicated loan to finance the transaction.

STOCKS, DOLLAR, BONDS

European shares were down sharply. The FTSEurofirst 300 .FTEU3 index of top European shares was down 1.2 percent despite strong earnings from Swiss engineering group ABB (ABBN.VX), Dutch chemicals group DSM (DSMN.AS) and Belgian drugmaker UCB (UCB.BR).

MSCI world equity index .MIWD00000PUS was down 0.7 percent, hitting its weakest since early July.

Earlier, Japan's Nikkei average .N225 fell 0.88 percent to hit its lowest close in nearly two months.

The yen rose broadly as investors bought back the Japanese currency they sold to fund purchases of high-return assets in so-called carry trades. This dragged the dollar higher, pulling it further away from this week's 15-year troughs against a basket of major currencies.

The euro fell to a 2-1/2 week low below $1.37 EUR= and the dollar hit a two-month low of 119.64 yen JPY=.

The euro zone 10-year bond yield EU10YT=RR fell 5.7 basis points to below 4.40 percent and the U.S. 10-year Treasury yiled was down 4.1 basis points at $4.8613 percent. (Additional reporting by Veronica Brown and Natsuko Waki)