By Richard Hubbard
LONDON (Reuters) - Signs of a deal to avert an economically damaging U.S. debt default boosted world equity markets and the dollar on Tuesday, though firm short-term interest rates highlighted concerns that the problem may just be postponed.
Hopes rose after U.S. Senate Majority Leader Harry Reid, a Democrat, and his Republican counterpart, Mitch McConnell, ended a day of talks on Monday, with Reid saying they had made "tremendous progress".
While markets remain wary over the eventual outcome, the signs of a last-minute deal were enough to lift Europe's blue chip index, the Euro STOXX 50 to a 2-1/2-year high and boosted shares across Asia to 5-month highs.
U.S. stock index futures signaled that Wall Street would extend its gains when trading opens, with the broad S&P 500 index lying less than one percent below an all-time record of 1,725 points set on September 18.
"The consensus is bullish, everyone believes that a deal will be reached," said Guillaume Dumans, co-head of research firm 2Bremans.
The gains around the world have lifted MSCI's world equity index, which tracks shares in 45 countries, by 0.2 percent, leaving it just three points below a five-year high hit in September prior to the crisis in Washington.
However, the reaction in the U.S. Treasury bill market was more muted as sources close to the negotiations revealed that the plans under discussion may only free the government to borrow more money to fund itself until mid-February 2014.
U.S. Treasury one-month bill yields were yielding around 26 basis points, little changed on the day but up from 2.5 basis points on September 30 just before the fiscal deadlock in Washington forced the government to begin a partial shutdown.
"There seems to be some progress being made but the solution that is being proposed is far from perfect. It's short-term, it's just pushing the problem further along for a few months," Philip Tyson, strategist at ICAP, said.
The dollar meanwhile shared some of the optimism over the prospects of a last-minute deal emerging this week, gaining 0.5 percent to hit a one-month high against a basket of major currencies.
Against the safety of the Swiss franc, the dollar was also at a one-month peak at 0.91455 francs though versus the yen, another refuge in times of uncertainty, it was little changed at 98.57 yen.
However, the gains in the dollar may be limited as the government shutdown is expected to have hurt the U.S. economic recovery, and has convinced many that the Federal Reserve will have to extend its monetary stimulus into next year.
"If we get some kind of temporary resolution in the U.S. it will still have a small positive short-term impact on the dollar. But in the medium term this is clearly dollar-negative," said Richard Falkenhall, currency strategist at SEB.
Elsewhere in the currency market, the Australian dollar jumped to a four-month high when minutes of the central bank's October 1 meeting revealed it was prepared to cut interest rates further though it was in no hurry to act.
In Europe's the brighter outlook for the region's economy was supported by the latest survey of analyst and investor morale from the influential ZEW Institute.
The think tank's monthly poll of economic sentiment rose to 52.8 in October from 49.6 in the previous month, its highest level since April 2010 versus a no-change consensus in a poll of 36 economists conducted by Reuters.
However the data had scant impact on the single currency which was little changed at $1.3557, well within a recent trading band of $1.35 to $1.36.
German 10-year government bond yields were at their highest levels in three weeks, up 3.5 basis points at 1.9 percent, though most of the move came before the ZEW data.
A separate report on price pressures in Britain showed inflation was higher than expected in September and house prices had risen sharply, adding to doubts over how long the central bank can hold down interest rates.
Gold, whose safe-haven appeal is usually burnished during times of uncertainty, fell to a fresh 3-month low and has now lost over 4 percent in value since a partial government shutdown began on October 1. It shed 1.2 percent to trade at $1,256.96 an ounce.
While in addition to the U.S. budget negotiations, oil traders were keeping an eye on talks in Geneva over Iran's nuclear programme that might eventually lead to a pick-up in its oil shipments.
Brent crude futures were trading 78 cents at $110.26a barrel at 1030 GMT, after ending lower in the two previous sessions.
(Additional reporting by Blaise Robinson and Jessica Mortimer; editing by Stephen Nisbet)