Oil near $126 hits stocks as credit worries back

LONDON (Reuters) - Oil prices bounded to nearly $126 a barrel on Friday, hitting global stock markets as worries also returned about the financial sector following losses at the world's largest insurer, AIG.

European shares were down more than 1.5 percent and Japan closed down more than 2 percent. Wall Street looked set for a poor start.

Weighing on many stocks was American International Group's (AIG.N) posting of its largest ever quarterly loss on Thursday after writing down assets linked to subprime mortgages. It said it would raise $12.5 billion to strengthen its balance sheet.

Investors are generally persuaded that the worst of the subprime woes and accompanying credit crisis is behind them, but are still highly sensitive to bad news on the subject.

Japanese shares were also shaken by Toyota Motor Corp (7203.T), the world's biggest automaker, forecasting its first annual net profit decline in seven years as it faces a triple blow of a stronger yen, rising materials prices and a slowing U.S. economy.

The Nikkei average closed down 2.1 percent or 287.92 points at 13,655.34. It has, however, gained nearly 20 percent from a year-low hit on March 17.

Europe's FTSEurofirst 300 was down 1.7 percent.

"(There are) writedowns at AIG and the capital raising, some poor results from European insurers, some stocks downgrades in the financial sector. And the oil price is pretty high, which might be unsettling people a little," said Kevin Gardiner, global equity strategist at HSBC.

HEADY OIL

Record high oil prices brought with them feats about global inflation, slow economic growth and costs to cut into corporate profits.

Oil rose to a fresh record just shy of $126 a barrel.

U.S. crude for June delivery rose as far as $125.98, surpassing the previous record of $124.61 hit on Thursday. Later, it was at $125.68.

"Funds are pouring into the crude market as prices have been performing extremely well," said Tatsuo Kageyama, analyst at Kanetsu Asset Management in Tokyo.

"Lingering geopolitical fears and high heating oil prices are helping the market, but the speed of the rise is too fast."

Gas oil futures, the benchmark for European heating oil and diesel contract, also surged to a new record high amid worries about tight global diesel supplies.

DOLLAR FALLS

The dollar fell broadly while the low-yielding yen benefited as high oil prices and falling stocks dented sentiment on the U.S. economy.

The euro added to gains made the previous session after European Central Bank President Jean-Claude Trichet said that inflation remained his top concern, suggesting the bank won't cut interest rates soon.

The euro had fallen to a two-month trough below $1.53 as some investors expected Trichet, speaking after an ECB meeting at which rates were kept unchanged, to temper his tough talk on inflation and focus on signs of slowing euro zone growth.

Against a basket of major currencies, the dollar was down 0.5 percent.

The euro was up 0.4 percent at $1.5463, nearly two cents above a two-month low of $1.5284 set on Thursday before Trichet's news conference.

The dollar was down 0.8 percent against the yen at 102.90.

Euro zone government bonds were higher, boosted by falling equity markets. The 10-year yield was down 5 basis points at 4.016 percent while the two year was down 4 basis points at 3.675 percent.

(Additional reporting by Antonina Vorobyova)