A market rally that had lasted two days came to a halt hours before a European Union summit that is not expected to produce a breakthrough agreement to remove the threat of Greece from abandoning the euro zone.
Comments made by former Greek prime minister Lucas Papademos about a possible euro zone exit by Greece only heightened investor anxiety. In an interview with The Wall Street Journal, he said that while he did not want to see the return of the drachma "it cannot be excluded that preparations are being made to contain the potential consequences of a Geek euro exit."
He later clarified his comments, insisting that he had no specific knowledge of institutions or countries preparing for euro zone exit.
By early afternoon, Central European Time, the FTSE-100 was down almost 1.8 per cent while the Eurofirst 300, the index of Europe's top stock market companies, had shed 1.6 per cent.
The euro's slide continued. By 2 p.m. CET, it was $1.265, down 0.23 per cent, after having touched $1.261, its lowest level since August, 2010. Yields on the sovereign bonds of Spain, which is trying to repair its gutted banking system, rose marginally to 6.11 per cent and oil was down about 1 per cent.
Investors were in part reacting Germany's insistence that it would not endorse euro bonds at tonight's informal leaders' summit in Brussels. The leaders of Italy, France have promoted euro bonds, as have the International Monetary Fund and the Organization for Economic Co-operation and Development. They argue that issuing debt backed by all 17 euro zone countries, including triple-A rated Germany, would greatly lower the borrowing costs of the weakest countries even if it raises costs for the strongest.
Without consensus on euro bonds, the summit is bound to emerge as a talking session in which some pro-growth initiatives, such as pumping up infrastructure projects, will be endorsed. "We doubt that Wednesday evening's EU summit will result in many groundbreaking concrete agreements," Barclays' analysts said in a note. "It seems unlikely that market confidence will return until there is more visibility about developments in Greece, and Europe more generally."
Many economists expect the euro to continue to weaken as Germany continues to resists euro bonds and the likelihood increases that Greece will leave the euro zone. But ING senior economist Martin van Vliet said the waning euro is positive development for the euro zone because it will make exports more competitive. He said "significant euro depreciation could be a key ingredient in preventing the current crisis from turning really ugly."
Mr. van Vliet acknowledged that a Greek exit was possible, after Greek voters earlier this month overwhelmingly endorsed anti-austerity parties. But he thinks the EU will do everything possible to keep the country within the fold. "Whether or not Greece indeed stays in, further action is likely from the European Central Bank," he said.
Since December, the ECB has propped up the banks with about €1-trillion of ultra-cheap loans. Some economists think it will have to pump another round of liquidity into the banks to stabilize them as investors in Greece and Spain withdraw funds, for fear their banks will collapse.
The ECB could also buy the bonds of weak euro zone countries to prevent their yields from soaring. The central bank bought bonds in some quantities last year, but has been highly reluctant to boost those purchases.