Dollar, stocks driven lower by credit jitters

LONDON (Reuters) - European shares extended earlier losses and the dollar hit a 26-year trough against sterling on Tuesday, weighed down by concerns over the credit market and its impact on corporate activity and the wider economy.

Repricing of low credit spreads, triggered by a fallout in the high-risk U.S. subprime mortgages sector, is fanning concern that firms could have difficulty financing the stream of M&A deals which has fuelled world stocks to lifetime peaks in July.

Investors are also worried that trouble in subprimes, which target borrowers with poor credit histories, will leave banks with bad loans, hurt corporate earnings and undermine consumer spending in the world's largest economy.

"These are risky markets with quite a few fundamentals deteriorating," said Morgan Stanley strategist Teun Draaisma, adding that credit spreads, interest rates and currencies were becoming a worry.

So far these concerns are viewed as a specific negative for the U.S. economy, with little signs of a broad sell-off in risky assets. The dollar is down as investors expect a U.S. interest rate cut, but other high-yielding currencies are unscathed.

"You have credit spreads widening, rate differentials at least towards the euro slowly narrowing -- these factors weigh on the dollar, so the sentiment is sill negative," said Antje Praefcke, currency strategist at CBCM in Frankfurt.

The dollar had fallen as low as $2.0655 per pound, its weakest since 1981, before trimming losses. It hit a two-month low of 120.42 yen.

The FTSEurofirst 300 index was down 0.6 percent on the day, with concerns about the export-damaging strength of the euro and the credit market overwhelming some positive Q2 earnings. The index hit a 6-1/2 year high earlier in July.

"We're heading for the dog days of August, and there's likely to be short-term volatility as investors get a more realistic picture of risk," said Justin Urquhart Stewart at 7 Investment Management.

U.S. stock futures showed a weaker opening on Wall Street, after disappointing profits from DuPont and Texas Instruments. Asian stocks ex-Japan, as measured by MSCI, hit a record high.

CREDIT GLOOM

Gloom over the credit market intensified with the closely-watched iTraxx Crossover index trading as wide as 375 basis points.

"Tightening lending standards in credit are important, with the availability and cost of LBO financing an important transmission mechanism from credit to equity markets," HBOS Treasury Services said in a note to clients. "The reduced tailwind from M&A activity will leave equity markets more vulnerable to earnings disappointments by the autumn."

Euro zone government bonds drew safe-haven support. The September Bund future was up 2 ticks.

Oil prices fell for a third day on expectations of rising U.S. fuel stockpiles and pledges from OPEC to pump more crude if needed. London Brent crude was down 1.4 percent at $75.78 a barrel after coming within $1 of life highs last week.

Gold inched higher to $682.65 an ounce, aided by a weaker dollar.