LONDON — A surprise contraction in the US economy in the fourth quarter hit shares on Wednesday and also helped keep the euro close to a 14-month high.

The data showed the world’s largest economy unexpectedly suffered its first decline in the fourth quarter since the 2007-2009 recession, which put a damper on the mood in financial markets ahead of a meeting of the US Federal Reserve.

There had been optimism earlier in the day, after several encouraging reports on the European economy saw the euro break above $1.35 for the first time since December 2011.

"It’s (gross domestic product) an awful number. This dashes hopes among investors that the Federal Reserve will move away from an ultra-easy monetary policy," said Joe Manimbo, senior market analyst at Western Union Business Solutions.

"This is a source of weakness for the dollar because it takes away the narrative that the US economy is performing better than the rest of the world."

The Fed is expected to maintain asset buying at $85bn a month when it concludes its meeting later, and stick to its commitment to hold interest rates near zero until unemployment falls to at least 6.5%.

The gross domestic product (GDP) data overshadowed a third straight rise in European economic confidence, European Central Bank (ECB) crisis-loan repayments, and a solid sale of five-and ten-year Italian bonds, which provided fresh evidence of the recent improvement in the region.

The disappointment left European shares down 0.3% by 1.45pm GMT. Wall Street was expected to open lower, although an earlier rise in Asian shares kept the MSCI world share index at a new 21-month high.

Alongside the rebound in confidence in the eurozone, one of the key drivers behind the currency’s recent spike has been the eagerness of banks to repay the crisis loans they took from the ECB just over a year ago.

Banks returned a larger-than-expected €137.2bn of those loans on Wednesday and also surprised analysts by trimming their three-month funding, despite predictions they would use it to partly restock their coffers.

"It (the euro rise) is just a carry-on with the current trend, risk is pretty healthy and equities are doing well," said Bank of Tokyo Mitsubishi strategist Derek Halpenny.

"The danger is European policy makers allow a spike (in euro and market rates) as a result of a removal of one of the principal support measures ... With the Fed and the BOJ (Bank of Japan) still easing, the euro is clearly the path of least resistance."

Confidence rally

The focus on the Fed decision will be on its outlook for the economy and its bond-buying programme after it sounded slightly more hawkish last month.

The earnings season also remains in full stride. Thomson Reuters data show that of the 174 companies in the S&P 500 that have reported so far, 68.4% have been above analysts’ expectations, which is above the long-term average.

Strong US housing data on Tuesday and China’s promising economic growth forecast for this year raised expectations for robust demand for fuel and industrial commodities, underpinning oil prices and lifting copper.

Brent crude oil reached its highest level in three-and-a-half months as it passed $115 a barrel leaving it up 3.5% so far this month.

"Oil has followed risk assets higher, but we think it’s strong versus the fundamentals, with production cuts needed from Saudi Arabia due to strong supply from Opec," cautioned Filip Petersson, an SEB analyst in Stockholm.

Mixed Europe

Eurozone economic sentiment improved more than expected across all sectors this month, rising for a third straight month in a sign the bloc’s economy could be emerging from a low point in the fourth quarter of last year.

However, figures showed Spain’s economy sank deeper into recession at the end of last year, shrinking at the fastest pace in a year, as budget cutbacks and high unemployment prompted households to slash spending.

An ECB survey of Europe’s banks also darkened the mood, showing that most expect to continue toughening up their lending rules in the coming months and see another drop in demand for loans.

In the bond market, traditional safe-haven German bonds fell after a solid Italian debt auction underscored the new appetite from yield-hungry investors for peripheral eurozone debt, although the disappointing US figures saw them pare losses, and US Treasuries also turned around an early slump.

Just six months ago, yields on Italian and Spanish debt soared, but the ECB’s promise to keep the euro together has prompted a turnaround.

Rome sold €3.5bn ($4.7bn) of 10-year bonds at 4.17% on Wednesday, its lowest cost since October 2010.

"What we’ve been seeing recently is increased demand, particularly from overseas, for Italian bonds, not just the short end, but particularly the longer end... I think today’s (Wednesday’s) auction provides further evidence that is indeed occurring," said Nick Stamenkovic, a bond strategist at Ria Capital Markets in Edinburgh.