Stocks steady but credit worries remain

NEW YORK (Reuters) - U.S. and European stock markets steadied on Wednesday, while bond prices rose, pushing the two-year Treasury note's yield down to 18-month lows as investors sought refuge from the credit sector's troubles in the relative safety of government debt.

The dollar also benefited, as U.S. investors continued to pare back their exposure to risky trades overseas, bringing cash back home into the safety of deposits.

U.S. stock indexes rose modestly, with the Dow Jones industrial average pausing after a tumble of nearly 1,000 points from a record high above 14,000 set on July 17.

But investors remained nervous, reflecting continued worries that a crisis in the subprime mortgage sector -- originally sparked months ago by a steep rise in foreclosures -- has not yet run its course.

"Clearly investors are not ignoring changing credit conditions," said Hugh Johnson, chief investment officer at Johnson Illington Advisors in Albany. "Like any period of financial distress, the tension is very, very high."

The Dow Jones industrial average .DJI was up 3.58 points, or 0.03 percent, at 13,032.50, after falling below 13,000 in early trade, its lowest in more than 3-1/2 months.

The Standard & Poor's 500 Index .SPX was up 2.17 points, or 0.15 percent, at 1,428.68. The Nasdaq Composite Index .IXIC was up 3.40 points, or 0.14 percent, at 2,502.52.

Shares of Countrywide Financial Corp. CFC.N, the largest U.S. mortgage lender, dropped as much as 9.2 percent after Merrill Lynch downgraded the stock to "sell" from "buy" and said bankruptcy may be possible if liquidity worsens. Countrywide later recouped some of those losses, but was down 4.4 percent at $23.39 in midday trading on the New York Stock Exchange.

The crisis in the U.S. subprime mortgage market has blown out credit spreads, slashed the returns of many hedge funds, and made it difficult for issuers of short-term debt such as commercial paper to roll over their loans.

The credit crunch also has raised concerns that financing for big mergers and acquisitions -- one of the key catalysts for buoyant global share prices in recent years -- will be harder to come by.

Government bonds in the United States, the euro zone and Japan continued to draw buyers on Wednesday, as investors bet that central banks with a hawkish bent were now less likely to raise interest rates, while the Federal Reserve was now closer to cutting rates.

The dollar index .DXY, a gauge of the greenback's value against a basket of six major currencies, rose a third of a percent and is now 2 percent above a 15-year low hit earlier in the month.

The two-year U.S. Treasury note US2YT=RR, which is particularly sensitive to expectations for interest-rate policy, was up 2/32 in price at 100-17/32, with its yield slipping to 4.33 percent from 4.36 percent late on Tuesday. Bond prices and yields move in opposite directions of each other.

The yield on the two-year note was more than 90 basis points below the Federal Reserve's 5.25 percent target for its benchmark federal funds rate over overnight bank loans. That's the furthest below a target rate that two-year notes have traded at in almost 6-1/2 years.

The benchmark 10-year U.S. Treasury note US10YT=RR was unchanged in price at 100-7/32, with the yield at 4.72 percent.

Treasury bonds have rallied since late last week, reflecting a view that the Federal Reserve is likely to cut interest rates next month to soothe financial markets and help the economy weather a downturn in the housing sector.

The FTSEurofirst 300 .FTEU3 index of top European shares slipped 0.19 percent to 1,491.79, wiping out most of its earlier loss of more than 1 percent.

In Tokyo, the benchmark Nikkei average .N225 dropped more than 2 percent to finish at its low for the year. Investors sold financial shares on renewed worries about a credit squeeze following the Dow's slide of more than 200 points on Tuesday. Investors also unloaded some shares of Japan's major exporters as they fretted about a potential slowdown in the U.S. economy.

The Nikkei lost 369 points, or 2.2 percent, to close at 16,475.61, the lowest close since December 8, 2006.

In New York energy futures trading, U.S. light sweet crude oil CLc1 rose $1.62, or 2.2 percent, to $74.00 per barrel. An unexpectedly steep drop in U.S. crude inventories and concern that output in the U.S. Gulf of Mexico could be cut by a storm increased supply concerns and helped lift oil prices.

COMEX most-active gold for December delivery GCZ7 rose 30 cents to $680.00 an ounce as the dollar pulled back a bit from its high against the euro.

(Additional reporting by Jennifer Coogan, Vivianne Rodrigues,

Ellen Freilich, Gene Ramos and Frank Tang in New York,

Sitaraman Shankar in London and Eriko Amaha in Tokyo)