LONDON—The ratings firm Moody's Investors Service late Monday dimmed its outlook on Germany, the euro zone's dominant economic power and political force, further exposing the currency bloc's fragility on a day that also saw markets drop around the world on fears about Europe.
Moody's cited the huge potential cost of a euro breakup and, alternatively, the steep bill that would be paid to hold it together.
The warning to Germany followed a dramatic flight by investors from Spanish bonds Monday, leaving the euro zone's fourth-largest economy at grave risk of needing a bailout and sparking a selloff on global markets.
Stock markets across Europe slumped sharply, with Greece down 7.1%, Germany off 3.2% and Portugal 3.4% lower. In Spain, the benchmark index was off more than 5% before the country's market regulator moved to ban short-selling of all stocks for three months. The index ended the day down 1.1%. Italy banned short-selling of financial stocks for a week.
In the U.S., the Dow Jones Industrial Average plunged early, declining almost 240 points before clawing back to finish 101.11 points lower at 12721.46.
Asian markets fell in early trading Tuesday, with Japan down 0.3%, Australia slipping 0.1% and South Korea steady. The Shanghai Composite lost 0.4% to reach an intraday low for the year.
In downgrading to negative its outlook on Germany's triple-A rating, Moody's pointed to the vast liabilities Germany would incur in a bailout of Spain and Italy, as well as its banking system's "sizable exposures" to them. Moody's also shifted to negative its outlooks on triple-A Netherlands and Luxembourg. Only Finland, more economically isolated than the other triple-A countries, now has a stable rating from Moody's.
The negative outlooks don't necessarily mean a downgrade is imminent, but they make clear how devastating a collapse of Spain and Italy would be. Spain is the euro zone's most acute challenge since the 17-nation currency bloc faced a near-catastrophic run on Italian and Spanish bonds last summer. The seminal issue now: how to keep Spain's deficit-running government financed. If private investors can't be lured back, Europe will need a fresh public stopgap.
"They have to stop this spreading to Italy," said Helen Haworth, head of European interest-rate strategy for Credit Suisse in London.
The two other principal ratings firms, Fitch and Standard & Poor's, both rate Germany triple-A with a stable outlook. A downgrade would be a raw wound for Germany, which has fiercely guarded its fiscal strength even as the euro crisis has deepened.
It would also call into question the strength of the euro zone's bailout funds, which are designed to take advantage of the bloc's strongest members' credit.
The Bank of Spain said Monday that gross domestic product shrank in the second quarter by 0.4% from the first quarter, citing a "substantial contraction" in public and private spending. Germany's central bank, meanwhile, said the country had probably grown "moderately," its shorthand for growth of between zero and 0.5%, following first-quarter growth of 0.5%.
In changing its outlook on Germany, Moody's also cited renewed concerns about Greece, saying, "The material risk of a Greek exit from the euro area exposes core countries such as Germany to a risk of shock that is not commensurate with a stable outlook."
The overarching worry about the cost to be paid by the euro zone's core countries was a principal reason for the lowered outlook. But Moody's also cited heavy German bank exposure to weak countries, high Dutch household debt and Luxembourg's unusual dependence on the financial-services industry. It said Finland's relative insulation from the euro zone—through limited trade and a small banking system, as well as its efforts to secure collateral from recipients of bailout aid—gave it a better cushion.
Among investors' chief concerns around the euro zone is that Spain won't be able to find buyers for the tens of billions in new debt it must issue this year to raise cash. That lack of demand results from a confluence of worries. Spain's economy is deteriorating rapidly, weighing on the government's ability to bring in tax revenue; its financially strapped regions may need help from the central government; and its sagging banking sector remains capable of dragging the country down.
Many investors fear Spain could be stuck in a downward spiral of slackening demand. The possibility that ratings firms could cut the country's precarious credit rating, thus forcing some institutional investors to sell, looms.
Spain needs to sell around €28 billion ($34 billion) more in bonds this year to cover its deficits and repay maturing debt, as well as more than €50 billion in short-term Treasury bills. It has leaned on domestic banks to scoop the debt up, but those banks' purchases are waning. This month, Spain canceled a mid-August bond auction.
After a binge of debt issuance in the first part of the year, "they are struggling to issue what they need to," said Ms. Haworth of Credit Suisse.
What is more, Spain's projections for debt issuance don't include extra funds that might have to be raised on behalf of the troubled regional governments, nor the additional money needed to patch a wider-than-expected budget deficit. Those needs could add around €30 billion, bringing the total to more than €100 billion.
Ms. Haworth said Spain will likely need a rescue package in the next three months. What form that could take isn't yet clear. One option, she suggests, is for Europe's bailout funds to commit to buying whatever bonds Spain needs to issue for a period.
On Monday, Spain's 10-year bond yield rose by nearly a quarter of a percentage point, to 7.51%, according to Tradeweb. There was an even sharper move among bonds maturing in the nearer term, suggesting investors smell trouble soon.
Monday's dramatic market moves suggest Spain may be stuck in a spiral that culminates in a bailout from other euro-zone countries.
"The rise in the 10-year yield well beyond 7% carries a very distinct reminder of events in Greece in April 2010, Ireland in October 2010 and Portugal in February 2011," said analysts at Bank of New York Mellon. "In each case, a decisive move beyond 7% signaled the start of a collapse in investor confidence that, in each case, led to a bailout within weeks," they added.
Another option—preferred by Spain—would be for the European Central Bank to intervene. In Spain's parliament Monday, Finance Minister Luis de Guindos hinted—without naming the central bank—that the ECB should step up. He said Spain, which has accepted aid for its banks, wouldn't need a full bailout.
The backdrop of a gloomy global economy has many cautious to tread in the now-risky corners of Europe. Over the weekend, Germany's economy minister said he had "great skepticism" that woebegone Greece could fulfill the tough terms of its bailout, raising again the specter of the country's departure from the euro zone.
"We aren't touching anything in Europe at the moment," said Humayun Shahryar of Cyprus-based Auvest Capital Management. Mr. Shahryar has long been bullish on U.S. Treasurys, and he thinks they have room to strengthen further.
"People really have to run with their money because it is not about return on capital, it is about return of capital," he said.
