Markets jolted as hopes for EU action wane

Japanese businessmen look closely at stock prices flashing outside a brokerage in Tokyo September 26, 2005.

NEW YORK (Reuters) - Investors dumped stocks, commodities and the euro on Thursday as investors began to lose hope that European leaders would produce a grand plan to solve the European debt crisis.

Trouble started when the European Central Bank squelched optimism for aggressive action to fight the region's debt crisis, and markets were knocked back further when Germany rejected proposals that would bolster the strength of a bailout fund late in the day.

Thursday's developments deflated some hopes that policymakers will be able to agree on a credible plan at an EU summit getting underway that will reassure investors and stop the euro zone's debt problem from deepening.

"The whole thing is just a mess. I have been hopeful something will get done, but it's hard to hold on to those hopes given their track record," said Thomas Roth, executive director in U.S. government bond trading at Mitsubishi UFJ Securities USA in New York.

ECB President Mario Draghi poured cold water on market expectations the bank could step up bond purchases, a measure that has been seen as key to stabilizing rising borrowing costs of highly indebted members of the euro zone.

In an ominous sign heading into a key EU summit, Germany rejected draft proposals that would increase the euro zone's firepower in dealing with the credit crisis, triggering a steep sell-off in U.S. stocks and the euro late in the day.

"Once the Germany comment on rejecting the draft came out, that is when the euro and the Dow both reversed from their afternoon highs," said Joe DeGeronimo, chief dealer at SMBC.

"The stock market falling late in the day means the euro is likely going to trade heavy into the Sydney and Asian session overnight."

In a draft obtained by Reuters, EU leaders plan to move up the introduction of a permanent bailout fund to July 2012 and give the facility a banking license.

Such a move would bolster the strength of the rescue fund, but a senior German source said Germany rejected the measures.

"That just spells more trouble ahead in the days to come," Peter Cardillo, chief market economist at Rockwell Global Capital in New York, said of Germany's rejection.

The Dow Jones industrial average .DJI ended down 198.67 points, or 1.63 percent, at 11,997.70. The Standard & Poor's 500 Index .SPX tumbled 26.66 points, or 2.11 percent, to 1,234.35. The Nasdaq Composite Index .IXIC gave up 52.83 points, or 1.99 percent, at 2,596.38.

The MSCI All-Country World Index .MIWD00000PUS was down 1.8 percent, while the FTSEurofirst 300 .FTEU3 slumped to a one-week closing low, down 1.5 percent.

The euro fell to a session low of $1.3288 on Reuters data, its lowest since November 30. It was last at $1.3343, down 0.5 percent.

"TWO STEPS BACK"

Draghi also announced unprecedented action to support Europe's banks, saying the ECB will start offering banks funding for 3 years, as well as easier collateral rules. The ECB also cut interest rates 25 basis points to 1 percent.

But markets appeared less concerned with the possibility of a liquidity crunch than they are with the high cost of debt for troubled countries, and yields on Italian and Spanish bonds jumped.

"One step forward, two steps back," said Alan Clarke, UK and euro zone economist at Scotia Capital. "The euro zone leaders might as well not bother. Pack their bags, go home, enjoy the weekend and do their Christmas shopping."

Draghi also took some of the steam out of another talked-about scenario, that the ECB would lend to the International Monetary Fund to help support debt-saddled euro zone economies.

Draghi said lending money to the fund was not compatible with European Union treaties.

"His comments here raise the risk that nothing will be announced this week on how the IMF's resources will be increased," said Greg Fuzesi, economist at JP Morgan Chase in London.

Meanwhile, Europe's banking watchdog said the region's banks must find more capital than previously expected to make them strong enough to weather the debt storm.

The leaders of France and Germany were in Marseilles ahead of the summit, lobbying for their plan to amend the EU treaty to toughen budget discipline.

Paris and Berlin need to win backing quickly for their plan if they are to have it ready as they hope by March, but several countries are skeptical of a treaty change.

German Chancellor Angela Merkel said she was convinced leaders would find a solution to the euro crisis at the summit.

Even safe-haven gold was hit by the selling. Spot gold fell 1.8 percent to $1,709.59 an ounce.

Other commodity prices were also hit by worries Europe was not doing enough to contain the credit crisis, with U.S. crude oil futures settling at $98.34 a barrel, down $2.15, or 2.14 percent.

Ten-year Italian government bond yields rose 44 basis points to 6.51 percent and Spanish 10-year government bond yields jumped 37 basis points to 5.82 percent.

(Additional reporting By Daniel Bases, Angela Moon, Richard Leong; Editing by Dan Grebler)