LONDON (Reuters) - Financial markets paused for breath on Tuesday after being battered a day earlier on euro zone debt concerns, with new warnings about contagion fuelling fears the crisis is heading for a new, more dangerous phase.
European shares -- still in the red for the year -- edged higher and the euro sat above two-month lows versus the dollar, both boosted somewhat by better than expected German business sentiment.
World stocks as measured by MSCI .MIWD00000PUS were up 0.2 percent, but only after hitting two-month lows during Monday's sell-off, wiping out a good portion of their spring rally.
The main driver behind Monday's shake-out was concern that a Greek debt default could put a new range of countries -- including Group of Eight member Italy -- into trouble.
It was triggered by another credit downgrade of Greece, a ratings outlook warning about Italy and a Spanish voter revolt against austerity.
Rating agency Moody's underlined the issue again on Tuesday, saying that a Greek debt default would spread to others, putting Portugal and Ireland at risk of multi-notch credit downgrades.
"A Greek default would be highly destabilising and would have implications for the creditworthiness of issuers across Europe," Moody's EMEA chief credit officer Alastair Wilson told Reuters.
"This would result in more highly polarised creditworthiness and ratings among euro zone sovereigns."
Euro zone governments and central bankers are at loggerheads over what is needed to stave off default or restructuring in Greece, primarily over the unwelcome precedent it would set for the currency bloc and its other highly indebted countries.
"The huge storm of risk reduction will rip through markets if the focus turns to Spain and Italy. It's clear they don't have money to bail out these countries," said Ayako Sera, a market economist at Sumitomo Trust and Banking.
"What we are seeing now could just be the beginning of it."
EYE OF STORM?
As is often the case after a heavy market day, investors took something of a breather on Tuesday, but without any sign that the underlying issue has been dealt with.
The euro hovered above its two-month low against the dollar, with its rise capped by the contagion worries. It was up 0.2 percent on the day at $1.4078.
"The amount of euro selling in the past few days has been huge. So I suspect a lot of euro long positions have been cleared. Some may probably be caught in short positions," said a trader at a U.S. bank.
European shares drifted higher, with the FTEurofirst 300 .FTEU3 up a quarter of a percent. The index fell 1.7 percent on Monday.
Analysts said longer-term outlook was positive, but short-term events could make equities volatile.
"The global economy is still doing well. Companies are very healthy and have a lot of cash in their balance sheets. As long as they continue to deliver profits, that's going to be helpful for the market," said Philippe Gijsels, head of research at BNP Paribas Fortis Global Markets in Brussels.
"But I would caution people to be careful and take some money off the table and make sure they have some cash in hands."
German bonds were lower as investors cashed in on the previous day's rally of core euro zone debt and digested Ifo business sentiment data suggesting Europe's top economy might retain its strong growth momentum longer than thought.
The cost of insuring Greek debt against default rose again. It costs 1.435 million euros to protect 10 million euros of exposure to Greek bonds.
Other peripheral CDS were little changed.