The euro neared a three-month low and safe-haven German bonds and the Japanese yen rose on Wednesday as political disarray in Greece and the rising costs of fixing Spain's banks fueled fears the euro zone debt crisis would take a sharp turn for the worse.
The concerns over Europe added to worries about the impact of softer growth in the U.S. on the global economy to push down European shares. Wall Street was also poised to open lower, oil prices were down for a sixth straight session and the commodity-linked Australian dollar hit new lows.
Spanish 10-year bond yields climbed back above 6% - a point away from levels deemed unsustainable - and investors kept a wary eye on Athens, where efforts to form a government were expected to fail, putting its bailout deal in doubt and raising the possibility of Greece being forced out of the euro.
"The sensitivity to political developments in Greece is largely a reflection that the probability of Greece exiting the euro, posing a significant threat to global financial stability, has increased," Lee Hardman, currency economist at Bank of Tokyo-Mitsubishi UFJ said.
The euro fell 0.2% to $1.2970, closing in on a three-month low near $1.2955 touched on Monday below the $1.30 to $1.35 range it has traded within for most of the year.
"We still think the euro will head lower with $1.2950 the level to break in the near-term," said Lauren Rosborough, senior FX strategist at Societe Generale, who have a medium-term target of $1.2500.
The Japanese currency was a big beneficiary of the weaker euro, climbing to a two-and-a-half month high versus the dollar of 79.61 yen as investors sought safety.
The dollar itself remained supported against a basket of currencies by its own status as a safe haven, with the dollar index <.DXY> up 0.2% at 79.943.
Some analysts argued fears of a Greek exit from the euro were overblown.
Credit Suisse said while the probability of Greece leaving the euro had risen, the massive implications the move would have for the major nations within the 17-member currency bloc still made it unlikely.
"We now put a 15% probability of Greece leaving the euro, up from a previous estimate of 5%," the bank's equity strategists said in a note.
The key reason this probability remained low was that 70% of the country's debt was owned by the official sector, which includes the IMF, the European Central Bank and the EU.
"If Greece left the Euro-area, then the default on sovereign debt would be worse than that if it stayed in the euro-area."
Spanish bank drain
Added to the fears over Greece were worries about the cost of cleaning up the Spanish banking system after financial sources told Reuters the government would demand its banks raise around a further 35 billion euros in provisions against loans in their property portfolios.
The government and the banks in Spain are belatedly recognising a multi-billion funding gap in the financial system linked to a 2008 property crash that has heightened fears the country may need an international bailout.
The impact of the cash demand on Spanish banks sent the main euro zone bank index down 3.3%, dragging down the FTSE Eurofirst index of top European shares by 1% to 1,007.80 points.
While the escalation in concerns about the euro zone and its potential to be a further drag of global growth pushed the MSCI world equity index down 0.6% to 315.79 and near lows last seen in February.
German debt gains
In the debt markets the fragility of Spain's banking system saw Spanish 10-year government bond yields climb 16 basis points to 6.03%, and above the 6% mark that could see the rise in yields accelerate if the break is sustained.
The cost of insuring Spain's debt against default also rose 19 basis points to 512 basis points.
And with investors fleeing the peripheral euro zone debt markets the German debt market, already offering ultra-low yields, posted new records.
The key 10-year German government bond set a record low yield of 1.524% and the German Bund futures contract hit an all-time high of 142.75.
The government was able to capitalise on the safe haven demand by selling old four billion euros of new five-year bonds with a record low coupon of 0.5%.
News that exports and imports rose to record monthly levels in March was another signal that Europe's largest economy is fending off the euro zone debt crisis far better than others.
In commodity markets Brent crude slipped towards $112 a barrel, on track for its longest losing streak in almost two years and U.S. crude was at $96.35, down 66 cents.
The commodity-linked Australian dollar also fell 0.5% to $1.0066, having touched a low of $1.0052 at one point, the lowest level in more than four months. The New Zealand dollar also touched a 4-month low at $0.7842.
The price of gold fell for a third day, touching a four-month low and all but wiping out its gains for the year.
"With deflation becoming more of a risk in some parts of the world, like Europe, and the Fed less inclined to do another round of QE3, the inflation hedge argument isn't as strong as it was a couple of months ago," said James Shugg, senior economist at Westpac.