World stocks fall sharply on renewed euro zone fears

Traders work on the floor of the New York Stock Exchange, February 1, 2013.

NEW YORK (Reuters) - Major stock markets fell on Monday and the euro tumbled from multi-month highs against the dollar and yen as political uncertainty in Spain and Italy revived worries that the steps taken to rein in the euro zone debt crisis could unravel.

The MSCI world equity index slipped 1.1 percent and was on track for its worst day since November. U.S. shares retreated and the S&P 500 had its worst day of the year, while European stocks posted their lowest close of the year as shares in Spain and Italy fell sharply.

Spanish 10-year bond yields climbed to six-week highs after Prime Minister Mariano Rajoy faced calls to resign over a corruption scandal involving allegations in the media that he received payments from a slush fund. Rajoy denies any wrongdoing.

"The prospect of Rajoy's resignation has roiled the markets," said Boris Schlossberg, managing director of FX strategy at BK Asset Management in New York.

"Any fresh political instability in (the) euro zone's most important periphery economy could undermine the sense of investor confidence and send Spanish yields higher, making it much more difficult for the government to implement its austerity measures."

In Italy, former Prime Minister Silvio Berlusconi, one of the top candidates in this month's general election, is seeing a resurgence in popularity, which threatens the reforms implemented by the outgoing technocrat government.

U.S. stocks fell after a disappointing report on factory orders, retreating from a rally on Friday that drove the S&P 500 to a five-year high and the Dow to close above 14,000 points for the first time since October 2007.

"The market is extended and due for a pullback. I think people are looking for an excuse to make sales, and there (is) the concern coming from Europe," said Michael James, senior trader at Wedbush Morgan in Los Angeles.

The Dow Jones industrial average ended down 129.71 points, or 0.93 percent, at 13,880.08. The Standard & Poor's 500 Index closed down 17.46 points, or 1.15 percent, at 1,495.71. The Nasdaq Composite Index fell 47.93 points, or 1.51 percent, to 3,131.17.

The FTSEurofirst 300 ended down 1.47 percent at 1,150.91, its lowest close since December 31. It had hit a near two-year peak of 1,178.55 in late January.

Spain's IBEX fell 3.8 percent, and Italy's FTSE MIB shed 4.5 percent.

EURO RETREATS BEFORE ECB

Spanish 10-year government bond yields rose as much as 24 basis points on the day to 5.45 percent, their highest level since mid-December, while Italian yields jumped 15 basis points to 4.48 percent.

The euro traded at $1.3515, down 0.9 percent. It had risen to $1.3711 on Friday, a level unseen since late 2011.

But the euro's dip may prove temporary, strategists said, and it could resume its move up if the European Central Bank, which is to hold a policy meeting on Thursday, expresses no concern about the currency's recent gains.

Against the yen, the euro was down 1.6 percent at 124.78 yen, off a 33-month high of 126.96 yen struck last week. The dollar fell 0.4 percent to 92.29 yen.

In commodities trading, Brent oil fell to a low of $115.32 per barrel before recovering slightly to settle at $115.60, down $1.16. Brent had risen for three straight weeks.

U.S. crude dropped $1.60 to settle at $96.17 per barrel after rising for eight consecutive weeks, the longest such winning streak since July-August 2004.

Oil prices had rallied in recent weeks on signs of an improving global economic outlook and geopolitical tensions in the Middle East.

Spot gold rose 0.4 percent to around $1,673 an ounce.

U.S. Treasuries prices rose as higher yields and a pullback in the stock market drew buyers. The benchmark 10-year U.S. Treasury note was up 18/32, the yield at 1.9601 percent.

Overnight, Asian shares climbed to 18-month highs. China added to the optimism about the global economy by reporting on Sunday that its services sector had grown for a fourth straight month in January, although the slim gain signaled that the global recovery under way is a modest one.

(Additional reporting by Caroline Valetkevitch and Nick Olivari; Editing by Dan Grebler)