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LONDON (Reuters) - European shares reversed course and fell on Tuesday after weak German factory data overshadowed signs of an improvement in China and sent the euro sliding towards two-year lows.
Germany's manufacturing sector contracted at its fastest pace in three years in July, suggesting Europe's largest economy may shrink in the third quarter as the country feels the effects of the region's debt crisis.
The Markit PMI index tracking the manufacturing sector slid to 43.3 from 45.0 last month, below the consensus forecast in a Reuters poll of 45.3 and well under the 50 mark that separates growth from contraction.
"The German manufacturing sector has been one of the key elements of the euro zone recovery and to see it contracting at this rate is really quite worrying," said Chris Williamson, chief economist at the data compiler Markit.
The euro fell to around $1.2104 after the data, just above a 25-month low of $1.2067 hit on Monday when concerns about Spain sparked a broad sell-off in financial markets.
The FTSEurofirst 300 index .FTEU3 of top European shares reversed early gains to be down 0.2 percent at 1,022.26 points, after it fell 2.4 percent to a three-week low in the previous session.
Spanish five-year government bond yields rose above 10-year yields for the first time since June 2001 on Tuesday, in a sign that markets think the risk of a big credit event has increased.
Five-year yields on Spanish bonds were up 2 basis points at 7.45 percent, while 10-year yields were 6 bps lower at 7.436 percent.
Spain faces a test later on Tuesday when it offers 3 billion euros in 3- and 6-month bills after its longer-term bond yields set fresh euro-era highs on Monday.
German bond yields also rose after ratings agency Moody's cut its outlook for the country, citing costs associated with a potential Greek exit from the euro zone and the possible need to provide support to Spain and Italy.
"Given the trade and financial linkages that Germany has with a shaky euro zone that news possibly shouldn't come any surprise," said Mike Ingram, market analyst at BGC Partners.
Commodity markets were taking their lead from the signs of improvement in China's giant manufacturing sector which emerged in the latest HSBC purchasing manager's index.
The index rose to 49.5 in July from 48.2 in June, growing at the fastest pace in nine months and nearing the 50 level that divides expansion from contraction, in part due to gains in new export orders.
Three-month copper on the London Metal Exchange jumped 1.3 percent to $7,494 per tonne, while Brent crude gained 40 cents to $103.67 a barrel, though it was off earlier highs above $104. (Editing by Anna Willard)