Financial markets remained volatile on Tuesday as continuing credit concerns snuffed out a strong early rally for short-dated US Treasury bills.

Wall Street stocks recovered from earlier lows to end mixed after hopes of a cut in US interest rates were spurred by comments from Christopher Dodd, the US senate banking committee chairman.

The overriding mood in the global markets remained cautious however as continued fears about a global credit crunch fuelled risk aversion and continued to drive a flight towards safer assets. “Volatility continues to plague financial markets as investors remain torn between a ‘requisite’ flight from risk and hopes over a near-term easing in monetary policy by the Federal Reserve,” said Neil Mellor, strategist at Bank of New York Mellon.

“Given that interest rate futures and financial markets in general have taken the Federal Open Market Committee’s statement on Friday as firm evidence of the Committee’s intent to cut rates in mid-September, then it is clear that current asset price levels are now hostage to their monetary policy ‘premium’,” he added.

Mr Dodd said that Ben Bernanke, the Federal Reserve chairman, had indicted he would use all available tools to calm market turmoil.

Interest rate futures had already fully priced in a cut in the Fed funds target rate by the US central bank’s next policy meeting in September.

Nick Kounis, senior economist at Fortis Bank, said he thought it “very likely” that the Fed would decide to cut the funds rate twice during the coming three months, with a distinct possibility of an easing before next month’s meeting.

But Mr Kounis added that he remained positive about the outlook for the US economy.

“Downward revisions to our growth forecasts will be very limited in size and we are likely to shave no more than one or two-tenths from growth in 2007 and 2008,” he said. “This leads us to think that the Fed will be forced to turn on its heels relatively soon after order has been restored to financial markets, and start hiking again from the middle of next year onwards.”

The reversal of fortune in the short-dated US government bond market saw the yield on the one-month Treasury bill swing higher, rising by 89 basis points on the day to 3 per cent. The three-month bill yield was 43bp higher on the day at 3.61 per cent. But there was solid demand further along the curve as the yield on the two-year note briefly dipped to 3.96 per cent, the lowest since September 2005, before recovering to stand lower at 4.02 per cent. The 10-year yield fell 4bp to 4.6 per cent.

In the currency markets, expectations of lower US rates undermined the dollar, sending the US currency back towards Y114. The yen further benefited from the latest bout of investor risk aversion.

Global equity markets put in mixed performances.

By the close of trade in New York, the S&P 500 index was up 0.1 per cent, the Nasdaq Composite was 0.5 per cent higher and the Dow Jones Industrial Average was 0.2 per cent lower.

But the rally came too late to help European stocks, and the FTSE Eurofirst 300 index ended flat at 1,482.29.

Asian equities largely built on Monday’s powerful rallies. In Tokyo, the Nikkei 225 Average rose 1.1 per cent, Sydney gained 1 per cent and Seoul added 0.3 per cent.

News that China would allow its citizens to invest directly in Hong Kong shares sent the Hang Seng index up as much as 4.7 per cent, although the benchmark drifted back to finish just 0.6 per cent higher.

In Shanghai itself, the composite index rose 1 per cent to a fresh record close. A decision by the People’s Bank of China to raise its deposit and lending rates, in a bid to stabilise inflation expectations, was announced after the market’s close.

Lena Komileva, economist at Tullett Prebon, said the tightening moves “confirm once again that Chinese policy is driven by domestic political priorities rather than consideration of international interests”.

In commodities, oil prices continued to slide as hurricane Dean showed signs of losing strength, easing concerns about possible damage to installations in the Gulf of Mexico. September West Texas Intermediate fell $1.65 to trade below the $70 a barrel level for the first time since early July.

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