The surprise Moody's cut, which came with a warning that more downgrades could come, overshadowed relief in share markets that China's economy grew in line with forecasts in the second quarter.

The downgrade serves as a potent reminder that despite recent efforts by euro zone policymakers, the single currency bloc and especially its periphery, remain mired in debt.

Italy hopes to raise up to 5.25 billion euros at an auction on Friday but its bond yields and debt insurance costs surged ahead of the sale.

"It's quite clear that there's a lot of skepticism about the Italian situation and there are fears in the market that this auction will not be as successful as it should," said Ralf Umlaf, a bond analyst at Helaba Landesbank Hesse-Thueringen.

The Moody's action piled more pressure on the euro, which was down to $1.2197, not far off a two-year low of $1.2166 hit on trading platform EBS the previous day and on track for a second straight week of losses.

It also boosted appetite for safe-haven German Bunds, with bund futures up 25 ticks to 145.09 compared with 144.84 at Thursday's settlement. Italian BTP futures slipped 118 ticks to 99.88.

Ten-year Italian government bond yields rose 12 basis points to 6.03 percent while five-year Italian credit default swaps jumped 15 basis points, according to Markit.

GOOD NEWS FROM CHINA

There was better news for world equity markets as data showed China's economy grew 7.6 percent in the second 2012 quarter. That helped the main world equity index .MIWD00000PUS recoup some of the previous session's 1 percent losses, gaining 0.25 percent.

While the data confirms China is growing at the slowest pace in three years, it soothes worries of a drastic hit to the world's No. 2 economy and also increases hopes for more stimulus policies.

"China has enough room for stimulation now and that is important for equity markets," Achim Matzke, European stock indexes analyst at Commerzbank, said. "China's CPI and PPI is coming down so that gives room for interest rate reduction and that is more important for equity markets going forward."

The Chinese data also reassured commodity markets.

Oil prices rose, with Brent crude futures up almost half a dollar and holding above $101 a barrel. On metal markets, copper, seen as a key growth barometer, saw 3-month futures rallying to a one-week high.

Emerging market equities .MSCIEF rose 0.7 percent. The China growth data also boosted the Australian dollar, which benefits from growth in its biggest export market.

On European equities, markets opened stronger with the FTSE Eurofirst 300 index of top shares .FTEU3 up 0.21 percent.

Italian and Spanish shares .FTMIB .IBEX however fell 0.7-0.8.

Focus is shifting now to the big U.S. corporate results for the second quarter, with JP Morgan, Wells Fargo and Google due to report earnings later on Friday.

U.S. corporate outlooks are at their most negative in nearly four years and companies that have already reported so far this season have shown lackluster growth, many of them citing Europe's woes as a prime concern.

(Additional reporting by Sujata Rao and Emelia Sithole-Matarise; editing by Philippa Fletcher)

• A Permanent Economic Emergency