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The downgrade on Tuesday was not entirely unexpected and served as a reminder that Europe's debt troubles extend beyond Greece, which has dominated news headlines over its second financial bailout.

Some economists think Ireland may also need additional support, and investors worry Spain and Italy could be next in line for aid.

"It goes to show that this whole crisis isn't over just yet," said Jay Bryson, global economist for Wells Fargo Securities in Cape Hatteras, North Carolina. "Even if they cough up some more money for Greece, and that looks like it's a done deal, it's not over."

The protracted sovereign debt struggle has darkened the global economic outlook, cooling demand for Asia's exports and leaving financial markets on edge.

Mohamed El-Erian, co-chief investment officer for bond fund PIMCO, said it was unlikely that Europe's troubles would constitute a "Lehman moment" that paralyses the U.S. economy, but it was a drag on an already disappointing recovery.

The debt troubles add another wrinkle to the European Central Bank's interest rate decision on Thursday. Economists widely expect the ECB to raise its benchmark rate, which would be the second hike this year, to try to cool inflation.

But the move could raise already high borrowing costs for Portugal and other so-called "peripheral" European countries. Yields on long-term Portuguese government bonds are well above 10 percent, more than three times higher than those of Germany.

MISSING TARGETS

Moody's Investors Service slashed Portugal's credit rating by four levels, to Ba2, causing the debt-laden Iberian country to follow Greece into junk territory below investment grade. Greece is rated much lower, at Caa1.

Portugal in April became the third euro zone country to request a bailout, after Greece and Ireland.

Moody's cited heightened concerns that Portugal will not be able to fully meet deficit reduction and debt stabilization targets set out in its loan agreement with the European Union and International Monetary Fund.

Portugal is receiving funds from a three-year, 78-billion-euro EU/IMF bailout program and does not need to issue long-term debt in the market until 2013.

But Moody's said there is an increasing probability Portugal will not be able to borrow at sustainable rates in capital markets in the second half of 2013 and for some time thereafter.

There was a "growing risk that Portugal will require a second round of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a pre-condition," Moody's said.

Of the three major ratings agencies, Standard & Poor's and Fitch Ratings both have Portugal at BBB-minus, the bottom of the investment grade range.

The first repercussions of the downgrade could come as early as Wednesday, when Portugal is due to place up to 1 billion euros in a 3-month Treasury bills auction. It may have to pay a higher premium to entice buyers.

Portugal's new center-right government said in a statement that Moody's did not take into account strong political backing for austerity after a June 5 election, and an extraordinary tax announced last week.

"BIT EXTREME"

Unlike the previous minority Socialist government, the new ruling coalition has a comfortable majority in parliament to pass austerity measures and reforms. It did acknowledge, though, that the rating cut "shows the vulnerability of the country's economy amid a debt crisis."

It also reaffirmed commitment to deepening and speeding up austerity measures that the country vowed to implement under its bailout pact, saying a strong macroeconomic adjustment was "the only way to reverse the course and restore confidence."

The country has to slash its budget deficit to 5.9 percent of gross domestic product this year after overshooting its target last year, when the gap was 9.2 percent, and then reduce it to 3 percent by the end of 2013.

Anthony Thomas, Moody's analyst for Portugal, told Reuters "evidence that Portugal is meeting or indeed exceeding its deficit reduction targets" could be a positive that may lead the agency to change its outlook on the country's credit rating to stable from negative.

But he also said the outlook depends a great deal on whether euro zone officials will require private-sector participation when extending new financing to the region's troubled countries. Right now, such participation is planned to be only voluntary so as not to cause ratings agencies declaring it a "credit event."

Filipe Garcia, head of Informacao de Mercados Financeiros consultants in Porto, said Moody's move was "a bit extreme" and was likely to exacerbate concerns over Portugal's debt.

"The capacity to return to the markets after a while depends on a more global, structural solution by Europe rather than on what each troubled country does. I think it's too early to think of a second bailout for Portugal right now, not this year at least," he said.

Garcia said the ratings agencies were not taking into account the European Union's political determination to avoid a euro zone member's default, despite the union's strong support for Greece, which is in a far worse shape than Portugal.

"Either they don't believe in the power of the political will by the European Union to avoid default, or they are underestimating this political union," he said. (Additional reporting by Daniel Bases in New York, Sergio Goncalves in Lisbon and Emily Kaiser in Singapore; Editing by Dan Grebler and Neil Fullick)

Investors are cautious ahead of Friday's U.S. payroll data and the Chinese inflation numbers expected to be out next week.

Spot gold hovered near a 1- week high as Moody's latest move reignited fears about other highly indebted peripheral euro zone countries, just as worries about Greece eased a little after it secured a new tranche of emergency loans from international lenders.

"While the market has moved on from Greece a little, there is still significant concern out there that it's not close to the end game," said Greg Gibbs, strategist at RBS in Sydney.

The euro fell to a low around 1.2093 Swiss francs, from above 1.2200, after Moody's cut Portugal's credit rating by four notches to Ba2, saying there is great risk the country will need a second round of official financing before it can return to capital markets.

Against the dollar, the common currency dropped about a full cent to a low around $1.4395, before recovering a bit of ground to $1.4428.

MSCI's Asia Pacific index excluding Japan .MIAPJ0000PUS fell 0.1 percent slipping further from Monday's one-month high with healthcare and information technology leading early losses.

Japan's Nikkei .N225 was trading mildly higher as it struggled to breach the 10,000 level although gains in commodity stocks helped drive the benchmark higher for a seventh day.

The Chinese banking sector is likely to come under pressure, keeping the Shanghai and Hong Kong markets on the back foot after Singapore state investor Temasek TEM.UL launched a $3.7 billion sale in two Chinese state-owned banks, Bank of China (3988.HK) and China Construction Bank (0939.HK).

The Temasek move comes a day after ratings agency Moody's warned that its credit outlook on Chinese banks may turn negative as China's local government debt may be understated by as much 3.5 trillion yuan ($540 billion).

Greece is still expected to default at some point and for most investors who have dumped bonds over the past two years and who are crucial to put the ailing economy back on its feet, the longer that is delayed, the longer it will be before they consider looking at Greek assets again.

A likely second bailout -- currently under tortuous negotiation -- is seen only as a means to buy time for euro zone banks to provision for eventual losses and protect the bloc's larger economies from contamination, while the reforms attached to the package will be hard to implement in the face of deepening public resentment.

"We would buy if the economy manages to reform itself and if the banking sector is self-funded, but I don't think that's going to happen on a five-year view," said Russell Silberston, head of global interest rates at Investec Asset Management, who manages $31 billion worth of fixed income assets globally.

"Our view is they also need to default before that."

Greek Finance Minister Evangelos Venizelos told Reuters on Monday he intended to return to market funding in the middle of 2014.

Most investors don't think that will happen without a major restructuring to make Greece's debt mountain sustainable and remove it from the downward spiral of constant deficit-cutting which will wreck any chance of economic recovery.

"For Greece, starting over is the only solution," said Kommer van Trigt, a bond fund manager with Robeco Group, managing about 40 billion euros ($57 billion)

Silberston said the "first default" was near as France's proposal for a voluntary rollover of Greek debt seemed to be gathering momentum. But that would not solve Greece's solvency problem.

With debt expected to reach 1.6 times its 2011 economic output, economists say Greece would need a primary budget surplus of about 5 percent of gross domestic product, compared with last year's 5 percent primary deficit, simply to stabilize its debt at current levels.

On the assumption that Greece's debt-to-GDP ratio would peak at 166 percent, Evolution Securities calculations show a haircut of about 64 percent would be needed to bring the ratio back to the ceiling of 60 percent agreed in the EU'S Maastricht Treaty.

The Greek debt curve fully prices in a 50 percent haircut on average, according to UniCredit. But imposing losses on bondholders before gaining credibility may be in vain.

Investec's Silberston said besides a haircut, he would want to see several quarters of primary budget surpluses achieved in a sustainable way -- and not through privatization revenues -- before buying Greek debt.

"The big problem with a major haircut is that ... you would still need to have a very high premium for people to buy Greek debt after that date because if you look historically at haircuts, they tend not to be in isolation," said Jack Kelly, an investment director on global government bonds at Standard Life Investments, which manages assets worth 157 billion pounds ($250 billion).

CHEAP IS NOT ENOUGH

After an immediate Greek default was avoided with 12 billion euros of emergency loans and a fresh round of belt-tightening measures agreed in Athens, yields on some of its debt have fallen by more than 200 basis points.

But at over 27 percent for two-year paper and 16 percent for the 10-year they are still punishingly high. Only short-term investors were behind the rally, which was also exacerbated by thin volumes.

Kelly said Standard Life, which sold its last holdings of Greek debt in June 2010, would only buy it back if it reached investment grade again or as part of a EU common bond, something Germany has ruled out.

Although rated above junk, Portugal and Ireland, the other bailed out countries in the euro zone, are also considered a no-go by long-term debt investors because of the risk they will be dragged down with the Greek crisis.

But those countries have a chance to turn things around faster than Greece. The best placed is Ireland, whose exports are more competitive and its labor markets more flexible.

"The numbers are a bit better for Portugal and Ireland," said van Trigt at Robeco Group. "At this point we are not really differentiating between Greece, Ireland and Portugal. Going forward, a country like Ireland has a better starting position."

THE RIGHT PRICE

With the timing and magnitude of any Greek debt haircut hard to predict because politics plays a greater role than mathematics, it is hard to assess what price would draw investors back into Greece.

A common comparison is Uruguay's debt restructuring in 2003, when the price for its 2012 bond rose from about 40 to 60 cents in the dollar immediately after the event.

Greece's June 2020 bond trades at 55 cents in the euro.

"At prices of under 50, there will be value in eight- or nine-year (Greek) bonds at some stage," said Ciaran O'Hagan, strategist at Societe Generale. "But only when accounts are rendered sustainable, e.g. through restructuring."

That only holds good if Greece avoids a unilateral and disorderly default like Argentina's in 2002. It organized large debt swaps in 2005 and 2010 yet is still shut out of debt markets.

Market pricing before any haircut could offer opportunities to buy on the view that Greek bondholders were too pessimistic about the extent of such a move. But it would not help Greece, as those investors may bail out soon afterwards and their spending would be small.

"Those would only be incredibly hot money," said Robert Talbut, chief investment officer at Royal London Asset Management, which runs assets worth 40 billion pounds ($64 billion). He added he would not take that risk. ($1 = 0.626 British Pounds) ($1 = 0.705 Euros)

(Editing by Ruth Pitchford/Mike Peacock)

New orders received by U.S. factories bounced back in May, boosted by demand for transportation equipment, a government report showed. The 0.8 percent rise was slightly below economists' forecast.

Equities had rallied for five straight days for a 5.6 percent gain on the S&P, rebounding from weakness over the past two months. Moves to avert a debt crisis in Europe and surprisingly strong regional business data helped lift some of the gloom on Wall Street.

"Factory orders -- I didn't get much reaction or pull from that," said Fred Dickson, chief market strategist at D.A. Davidson & Co. Lake Oswego, Oregon. "We've had a big rally; it's time for consolidation."

Volume is expected to remain low in the holiday-shortened week, which could increase volatility. Markets were closed on Monday for the Independence Day holiday.

The Dow Jones industrial average .DJI dropped 23.42 points, or 0.19 percent, to 12,559.35. The Standard & Poor's 500 Index .SPX declined 4.23 points, or 0.32 percent, to 1,335.44. The Nasdaq Composite Index .IXIC fell 5.24 points, or 0.19 percent, to 2,810.79.

Southern Union Co advanced 3 percent to $41.59 after pipeline operator Energy Transfer Equity LP (ETE.N) raised its bid to buy its rival by 21 percent to about $5 billion, trumping the $4.9 billion bid offer from Williams Companies Inc (WMB.N).

Immucor Inc (BLUD.O) surged 30.2 percent to $26.98 after the diagnostics firm said it agreed to be acquired by private equity group TPG Capital for a fully diluted equity value of $1.97 billion.

(Reporting by Chuck Mikolajczak; Editing by Kenneth Barry)

The Commerce Department said on Tuesday orders for manufactured goods rose 0.8 percent after a 0.9 percent fall in April. Economists had forecast factory orders rebounding 1.0 percent in May.

Manufacturing is leading the economic recovery, with data on Friday showing a pick-up in the sector as the Institute for Supply Management's manufacturing index rose to 55.3 in June from 53.5 in May.

Details of the May factory orders report suggested an easing in supply chain disruptions after the March earthquake in Japan that had hampered factory activity.

The Commerce Department report showed orders excluding transportation edged up 0.2 percent in May after a similar gain the prior month.

Unfilled orders at U.S. factories rose 0.9 percent in May, the biggest increase since September, after a 0.6 percent gain in April. Shipments edged up 0.1 percent after falling 0.4 percent in April.

Inventories at U.S. factories increased 0.8 percent in May to $593.0 billion, the highest level since the series started in 1992.

The department revised durable goods orders for May to show a bigger 2.1 percent rise rather than the previously reported 1.9 percent increase. Excluding transportation, orders for durable goods were up 0.7 percent in May instead of 0.6 percent.

The increase in orders for non-defense capital goods excluding aircraft, seen as a measure of business confidence, was unrevised at 1.6 percent.

(Reporting by Lucia Mutikani, Editing by Chizu Nomiyama)