LONDON - The euro rose against the dollar and shares gained on Tuesday as Europe's worsening debt crisis and its impact on global growth encouraged talk of a policy response by the world's major central banks.

US stock index futures also edged higher on Tuesday ahead of a two-day policy meeting of the US Federal Reserve, with attention focused on whether it will unveil any more stimulus to support a flagging recovery.

Meanwhile, a surprise fall in British inflation strengthened the chance of steps from the Bank of England to support the UK economy as it feels the heat of the euro zone's problems.

"Everything is pointing towards another liquidity injection into the system," said Francois Savary, chief investment officer at Swiss bank Reyl.

Gains in riskier asset markets were limited by concerns over a sharp rise in Spain's short-term borrowing costs, a big fall in German investor confidence and fresh worries about Greece's commitment to its bail-out plan.

The single currency was up 0,3% at $1,2622, still below a one-month high of $1,2748 hit on Monday.

The pan-European FTSEurofirst 300 share index rose 0,75% to 1001,19 points, while Brent crude fell close to a 17-month low of $94,44 a barrel due to fears about the slowing euro-zone economy.

SPANISH YIELDS JUMP

Spain was forced to pay yields of more than 5% to sell 12- and 18-month Treasury bills in an auction as investors worried the country would soon have to ask for international aid.

It faces a bigger test on Thursday with a sale of longer-term bonds.

"The yields are more than 5% in both lines, which is back at the levels we saw in November 2011 when the market was in huge distress and the European Central Bank (ECB) was forced to intervene," said Peter Chatwell, an interest-rate strategist at Crédit Agricole.

Borrowing costs across the euro zone fell sharply after the ECB flooded the market with about ?1-trillion in cheap credit through two long-term refinancing operations (LTROs) in December and February, but they have since leapt back up.

Spain has called on the ECB to take more steps to ease the crisis, but the bank's head, Mario Draghi, said this month that it was up to Europe's politicians to fix the euro zone.

However, he has hinted the bank may soon cut interest rates, pointing to downside risks for the economy and saying there was no inflation risk in any euro-area country.

Spain's debt problems and uncertainty over the Greek election outcome took its toll on investor sentiment in Europe's biggest economy, according to the Mannheim-based ZEW economic think-tank's monthly poll.

The ZEW index fell in June at its fastest rate since October 1998, to -16,9 from 10,8 in May, way below the forecast in a Reuters poll of 42 analysts for a drop to 4.

"In the second quarter, Germany's economy is likely to slow down markedly, in particular private investment," said Christian Schulz, senior economist at Berenberg Bank.

"With the euro crisis once again threatening to push the German economy into recession this summer, a convincing policy response becomes pivotal for Germany as well," he said.

The concerns about Greece have also not gone away despite signs that Greece's pro-bailout conservatives looked set to form a coalition government with the Socialists.

Conservative New Democracy leader Antonis Samaras has promised to negotiate less punishing terms for Greece's international bail-out, after only narrowly beating a radical left-wing party that campaigned to scrap the austerity deal.

Any move by Greece's to change details of its ?130bn bail-out is expected to be opposed by Germany.

OPERATION TWIST

Gold prices rallied for their eighth consecutive session on Tuesday as investors cautiously dipped their toes back into the market, with the Federal Reserve's policy meeting in sharp focus for hints on sentiment towards extra policy stimulus.

The consensus has been for the Fed to announce no further quantitative easing - effectively creating money to purchase assets. But the recent disappointing economic data may prompt the Fed to consider extending its long-term bond-buying programme, known as Operation Twist, by a few months from the current June deadline.

"Economists largely anticipate some form of sterilised asset purchases and an extension of Operation Twist," said Morgan Stanley executive director Gabriel de Kock.

The liquidity boost delivered by previous doses of monetary stimulus from the Fed has lifted global equities and most commodities, and markets have become sensitive to speculation about future measures.

Gold stood at $1630,55, just off an intraday high of $1632,90 although the market is still a long way off the record seen last year at $1920,30.

Ahead of the Fed decision, signs that the euro-zone economy would remain subdued and keep oil demand weak hurt prices.

Brent crude futures briefly slipped to $94,44 a barrel, the lowest since January 2011 before recovering to trade about 63 cents lower at $95,43. US crude was 19 cents lower at $83,08 a barrel.

REUTERS