LONDON - European stocks gained ground on Wednesday while U.S. Treasury yields dipped after reaching multi-year highs as recent surging oil prices stoked inflation worries, setting the scene for the Federal Reserve to project rates staying higher for longer.
Yet in Europe, sterling came under pressure after data showed Britain's high inflation rate fell unexpectedly in August, prompting speculation that the Bank of England could pause its historic run of interest rate hikes as soon as Thursday.
Brent crude futures fell 0.8% and eased off 10-month highs. But at around $93.60 a barrel, prices remain up 30% in three months as Saudi Arabia and Russia reduce output.
Higher energy costs led to a bigger-than-expected spike in Canadian inflation, lifting the loonie on Wednesday and triggering selling in bond markets around the world.
The Federal Reserve is expected to leave rates unchanged at the current range of between 5.25% and 5.5% when it concludes a two-day meeting later on Wednesday.
Its policy statement is expected at 1800 GMT, followed by a press conference with Fed chief Jerome Powell.
"While the Fed is not expected to change their policy rate today, the U.S. rate market has been scaling back expectations for rate cuts in 2024 ahead of today's FOMC meeting that has helped to lift short-term U.S. rates," said MUFG senior currency analyst Lee Hardman, referring to the Fed's rate-setting body.
Two-year Treasury yields were down 3.5 basis points in London trade at 5.07%, having risen sharply on Tuesday, when five- and 10-year Treasury yields reached 16-year highs.
Benchmark 10-year Treasury yields were last trading at 4.34%, having hit 4.371% overnight.
WAITING ON THE FED
The Fed meeting leads a week jammed with central bank meetings, with policy announcements in Sweden, Switzerland, Norway, Britain and Japan all due later in the week.
World stock markets were edging higher ahead of the Fed rate decision.
European stocks were up 0.7% and U.S. equity futures were also rising.
In Asia, MSCI's broadest index of Asia-Pacific shares outside Japan fell 0.5% with Hong Kong stocks dragging as China left lending rates on hold. Japan's Nikkei fell 0.7%.
Sterling underperformed most other major currencies after the British inflation data, and was last trading 0.25% lower at $1.2365.
UK gilt yields fell sharply as investors slashed bets for a rate hike on Thursday, with two-year yields last down over 14 bps at 4.85%.
"With today's data, two out of the three indicators that the MPC (Monetary Policy Committee) has set out to monitor inflation persistence have now shown notably more progress than anticipated since the August meeting," Goldman Sachs economists, led by Sven Jari Stehn, said.
"Combined with their recent dovish commentary, we now expect the MPC to keep Bank Rate unchanged tomorrow and lower our forecast for the terminal policy rate to 5.25%," Stehn and co. added.
Japan's yen meanwhile continued to face pressure, prompting a riposte from Japan's top financial diplomat.
Masato Kanda told reporters that Japanese authorities were always in close communication with U.S. counterparts and that he wouldn't rule out any options if "excessive moves persist."
The yen is down 11% on the dollar this year as expectations firm for U.S. rates to stay high and Japanese rates to stay low, earlier hitting a 10-month trough of 148.17 per dollar.
Benchmark 10-year Japanese government bonds are at 0.72%, but have been creeping towards the Bank of Japan's adjusted tolerance for yields 1% either side of zero.
The euro was a touch firmer at $1.0704. Commodity exporters' currencies were firm, with the New Zealand dollar holding modest recent gains at $0.5964 after strong dairy price gains at auction.
The Aussie held at $0.6486 and analysts said markets might be more sensitive to a dovish surprise from U.S. policymakers.
"We think that the market may already be semi-braced for a hawkish pause," said DBS strategist Eugene Low in Singapore.
"Short of the Fed delivering beyond what is reasonably expected - that is, hiking rates or removing two cuts per year - we think upside to two-year and three-year dollar rates may be limited."
Rising yields have kept a lid on gold prices, with spot gold last trading at $1,930 an ounce.
(Reporting by Dhara Ranasinghe and Samuel Indyk in London and Tom Westbrook in Singapore; Editing by Toby Chopra and Chizu Nomiyama)