LONDON/HONG KONG: European shares fell on Wednesday as bond markets suggested pain ahead for the U.S. economy, tempering hopes of a negotiated end to the Ukraine conflict that had earlier buoyed equities.
The broad Euro STOXX 600 fell 0.8% in early trade after three sessions of gains that have taken the index back to levels reached before Russia invaded Ukraine.
Benchmark indexes in Frankfurt and Paris lost 1% and 1.3% respectively, with London shares also slipping a touch. Among significant losses was drugmaker Roche , which dropped 1.3% after a lung cancer drug failed to meet targets in a late-stage trial.
Bond investors had bet overnight that aggressive tightening of policy by the U.S. Federal Reserve could harm the world's biggest economy over the longer term.
The widely tracked U.S. 2-year-10-year Treasury yield curve briefly inverted on Tuesday for the first time since September 2019.
Longer-dated yields falling below shorter ones indicate a lack of faith in future growth, with 10-year yields falling beneath 2-year rates widely viewed as a harbinger of recession.
Market players said the signals coming from bond markets were at odds with the mood in equity markets.
"It's a complete diversion of fixed income and the equity market," said Sebastien Galy, senior macro strategist at Nordea Asset Management.
"Equity markets are overly optimistic and the fixed income markets are probably being overly pessimistic."
An inverted Treasury curve has in recent decades been followed by a recession within two years, including the 2020 downturn caused by the COVID-19 pandemic.
Shares rallied in Asia and Wall Street overnight after Ukraine had proposed on Tuesday that it take on neutral status, seen as a sign of progress in face-to-face peace negotiations.
On the ground, however, reports of attacks continued and Ukraine reacted with scepticism to Russia's promise in negotiations to scale down military operations around Kyiv.
MSCI's broadest index of Asia-Pacific shares outside Japan rose 1.3% to its highest in nearly a month, with most Asian stock markets in positive territory.
Yet the rally fizzled, with U.S. S&P 500 futures turning negative and pointing to losses of about 0.3%.
The MSCI world equity index, which tracks shares in 50 countries, was up 0.1%.
"That both sides might be edging closer towards one another has seen markets reduce the perceived likelihood of further escalation scenarios," Deutsche Bank analysts wrote.
"The alternative view is that the Russians are simply diverting resources to other areas and this is purely tactical."
JAPAN IN FOCUS
The benchmark U.S. 10-year yield was last at 2.3835% , having risen as high as 2.557% on Monday for its highest since April 2019, as traders position themselves for quickfire increases to interest rates by the U.S. Federal Reserve.
The impact of rising U.S. yields played out elsewhere, dragging Japanese government bond yields in their wake in a threat to Japan's ultra loose monetary policy.
The Bank of Japan increased efforts to defend its key yield cap on Wednesday, offering to ramp up buying of government bonds across the curve, including unscheduled emergency market operations.
The widening gap between U.S. and Japanese yields has caused the yen to weaken sharply, but it managed to regain some lost ground on Wednesday.
The Japanese currency rose 0.8% to 121.87 per dollar, compared with Monday's low of 124.3, with traders pointing to rising fears that Japanese authorities might step in to bolster the yen.
Elsewhere in currency markets, the euro was up 0.3% at $1.11, supported by the Russia-Ukraine peace talks.
(Reporting by Tom Wilson in London and Alun John in Hong Kong Editing by Simon Cameron-Moore and David Goodman)