Investors sold European stocks and bought government bonds and gold as trading got underway for the second half of 2007 on Monday, driven by security concerns after weekend bomb plots in Britain and higher oil prices.
Credit markets softened as worries lingered about the U.S. high-risk mortgage sector. Concerns about rising borrowing costs ahead of an expected interest rate hike in Britain this week also weighed on investor risk appetite.
Britain has raised its security rating to its highest level after failed car bombing attempts in London and an attack on a Scottish airport over the weekend.
We still have this flight to quality trade environment in addition to financial risk in the U.S. We had some geopolitical risk emerging in the UK triggering flight to quality, said Patrick Jacq, interest rate strategist at BNP Paribas in Paris.
The FTSEurofirst 300 index of top European shares was down 0.4 percent while London stocks were down 0.3 percent Airline shares were lower, with the DJ Europe Stoxx travel & leisure index down more than 1 percent.
U.S. stock futures were pointing to a firmer start on Wall Street later.
The September Bund future was up 50 ticks. Citi's world government bond yield ended the first half of 2007 at 3.8817 percent, up 47 basis points since the start of the year.
Ten-year swap spreads -- one gauge of investor view on riskier assets -- had widened to near 64.5 basis points.
BNP Paribas said the levels represented their highest level since 2002, a period when the United States was in a recession.
CREDIT, LIQUIDITY CONCERNS
Over the past week concerns had grown that credit problems in U.S. subprime mortgages could raise borrowing costs for companies, squeeze liquidity and spread to the world economy.
This helped ease risk appetite among investors who had pushed stocks to a record high in June and drawn yen-funded capital into high-return assets.
Reflecting credit concerns, the iTraxx Crossover, made up of 50 mostly junk-rated credits, widened to 245 basis points from around 227 in London on Friday.
Sterling edged closer to April's 26-year high against the dollar ahead of an expected interest rate hike this week. UK rates, at 5.5 percent, are already the highest in the G7.
The UK at the whole economy level does not have any spare capacity and actually has a positive output gap, which means that output is running ahead of its long run potential. This will lead to a build up of inflation pressure in the economy, Lloyds TSB said in a note to clients.
Goldman Sachs said re-acceleration in consumer inflation in developed economies remain a clear risk to the outlook for financial market returns.
It said average one-year ex-ante real rates -- measured by one year nominal rates deflated by the year-ahead inflation expectations -- in the United States, Japan, UK and the euro zone have now risen to 2.7 percent -- compared with the 1.7 percent average of the past decade.
Weakening equities prompted investors to unwind carry trades funded by low-yielding currencies, aiding the yen and the Swiss franc and weighing on the dollar.
London Brent crude steadied at $71.39 a barrel after rallying on Friday on falling gasoline and crude stocks in the United States. Gold, traditionally seen as a safe haven asset, rose to $651.45 an ounce.