A report showing business activity in the U.S. Midwest contracted this month for the first time since September 2009 knocked U.S. stocks lower while the dollar strengthened against the euro as investors shunned risk.

The MSCI index .MIWD00000PUS of world stocks was down 0.7 percent. Madrid's IBEX .IBEX led the falls, down 1.7 percent as an early lift from Spain's new round of spending cuts collapsed.

"At some point that (Spanish) credibility issue is likely to come back," said Derek Halpenny, European head of FX research at Bank of Tokyo Mitsubishi in London. "This is the fifth package - so the history of previous packages is that they weren't enough and lacked credibility."

The Dow Jones industrial average .DJI was down 85.51 points, or 0.63 percent, at 13,400.46. The Standard & Poor's 500 Index .SPX was down 9.47 points, or 0.65 percent, at 1,437.68. The Nasdaq Composite Index .IXIC was down 22.30 points, or 0.71 percent, at 3,114.30.

Despite Friday's losses, the S&P has advanced around 5.5 percent over the past three months.

Spain will remain in focus, analysts said, with the results of an independent audit of the country's banks to be published later in the day, while Moody's Investors Service is expected to finish a rating review which may cost Madrid its sovereign investment grade status.

Investors fretted the euro zone was failing to gain control over its debt crisis as Spain's borrowing costs rose back above 6 percent and France reported increased debt. The 10-year Spanish bond last yielded 5.96 percent after peaking at 6.079 percent.

The spending cuts announced by Spain had temporarily raised hopes the way was open for a bailout by the European Central Bank, which would buy Spain's debt in an effort to lower its crippling borrowing costs.

Euro zone inflation data added to upward pressure on the single currency as a surprise rise in Eurostat's flash September reading cast doubts over the near-term chances of another interest rate cut from the ECB.

France is also under the microscope and President Francois Hollande's fiscal credibility on the line. His first annual budget, France's toughest in 30 years, raised taxes to bring in 30 billion euros ($39 billion) to keep deficit-cutting promises.

France announced its public-sector debt rose almost 2 percent to 91 percent of gross domestic product. Greece's battered economy showed little sign of recovery as the latest retail data showed sales plunged 9.1 percent year-on-year in July.

The euro fell 0.5 percent to $1.2850 as risk aversion rose after the U.S. data. The dollar gained 0.5 percent against the yen, while the euro fell 0.1 percent against the Japanese currency.

But despite its wobbling economy and the negative sentiment it conveys for risk assets elsewhere in the world, China's yuan hit an all-time high versus the dollar.

The benchmark 10-year U.S. Treasury note was up 9/32, with the yield at 1.6232 percent.

"We had been seeing good data recently, but now we seem to be following the slowdown in China and Europe and we're seeing weakness," said Paul Nolte, managing director at Dearborn Partners in Chicago.

In commodity markets, gold surrendered gains on Friday as the dollar rallied on risk aversion but the metal stayed on track for its biggest quarterly gain in more than two years on the back of this month's central bank easing measures.

Oil markets were steady with those investors more inclined to look at tight gasoline supply in the United States.

Brent crude futures for November were flat at $112.00 per barrel. U.S. crude rose 0.1 percent to $91.95.