Fears of a possible Dubai debt default rippled through markets for a second day on Friday, but the exodus from stocks and rush to the safe-haven U.S. dollar slowed as investors discounted contagion.

U.S. stocks fell more than 1 percent, the first day of trading there after Dubai on Wednesday said it would ask creditors of two flagship firms, including conglomerate Dubai World, for a standstill on debt payments as part of a restructuring.

But euro stocks rebounded a day after falling 3 percent on the Dubai news, which particularly hit bank stocks.

The potential magnitude of the event, measured by Dubai World's $59 billion in debt, unhinged markets on concern that the hangover from the credit-driven property boom may hold more harsh surprises for banks.

Europe's rebound and U.S. stocks, which pared losses by the end of a shortened trading session, signaled that investors expected the event would not upset the global economic recovery. U.S. markets were closed on Thursday for a holiday.

What we've seen is that once the dust settles, some of the markets that were hardest hit have rebounded, said David Katz, chief investment officer at Matrix Asset Advisors in New York. It's a scare to the markets, but the U.S. has less exposure to Dubai than Middle Eastern and European banks.

The MSCI world equity index <.MIWD00000PUS> fell 1 percent, posting its second consecutive weekly loss, after earlier tumbling nearly 2 percent.

The MSCI since October has had trouble extending the rally that began in March as investors have raced to lock in gains ahead of year-end accounting. The index is still up about 70 percent since early March.

The Dubai announcement served as a catalyst to an overdue correction to markets whose valuations have outpaced economic and corporate realities, Mohamed El-Erian, chief executive officer of Pacific Investment Management Co. told Reuters.

Dubai struggled to ease fears of debt default by saying its profitable DP World , which runs 49 ports around the world, would not be involved in the restructuring. DP World, which has $3.25 billion outstanding bonds, is majority owned by Dubai World but has shares listed on NASDAQDubai.

The emirate is a center for investment and a major source of capital for Western markets.

On Wall Street the Dow Jones Industrial Average <.DJI> fell 154.48 points, or 1.48 percent, to 10,309.92. The Standard & Poor's 500 Index <.SPX> slid 1.72 percent to 1,091.49 and the Nasdaq Composite Index <.IXIC> declined 1.73 percent to 2,138.44.

In Europe the FTSEurofirst 300 <.FTEU3> index of top European shares rose 1.16 percent to 999.59, after falling more than 3 percent on Thursday.

Investor appetite for risky assets in Europe bounced, with the VDAX-NEW volatility index <.V1XI> down 4.5 percent, after a 23 percent jump on Thursday. The higher the index, which is based on sell and buy options on Frankfurt's top 30 stocks, the lower the market's desire to take risk.

The U.S. market volatility index <.VIX> rose more than 20 percent to its highest level since November 6.

The dollar rose as fears of a possible Dubai debt default sent investors to safe havens. Against a basket of currencies <.DXY>, the dollar climbed 0.23 percent to 75.00

A combination of systemic risk fears and thin market liquidity due to the U.S. holiday season has proven to be a combustible mix and several currencies or currency blocs are feeling the impact, UBS currency analysts wrote in a note.

The wider fallout has simply revealed how fragile both markets and risk appetite still are, they said.

The yen hit a 14-year high against the dollar before retreating when the Bank of Japan stepped close to currency intervention by checking exchange rates with commercial banks. The dollar climbed 0.3 percent to 86.74 yen, while the euro fell 0.31 percent at $1.4964.

Commodity prices extended previous session's steep losses, with crude oil under pressure. U.S. light sweet crude oil fell $1.90, or 2.44 percent, to $76.06 per barrel. Spot gold fell $20.05, or 1.68 percent, to $1172.50.

Euro zone government bonds and U.S. Treasuries rose in other flight-to-quality trades. The benchmark 10-year Treasury note yield declined 0.06 percentage point to 3.21 percent, the lowest on a closing basis since October 7.

(Additional reporting by Ryan Vlastelica and Jennifer Ablan in New York, Atul Prakash, Jamie McGeever, Simon Falush and Natsuko Waki in London and Blaise Robinson in Paris; Editing by Kenneth Barry)

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