Fears of a resurgence in the euro zone debt crisis boosted demand for safe-haven German bonds on Wednesday, while the Bank of England and a European Central Bank official signalled more monetary policy easing measures were unlikely.
The single currency also fell against the dollar as growing bad loan problems at Spanish banks added to the country's economic woes, and French president Nicolas Sarkozy, fighting for re-election, warned a strong euro hurt exporters.
"Investor demand for core paper remains firm, with the background threat of crisis tensions ratcheting yet higher, underpinning an overriding desire for capital preservation," said Rabobank strategist Richard McGuire.
The concerns about a flare-up in the euro zone debt crisis, which have largely centred on Spain's budget problems, allowed Germany to auction 4.2 billion euros in new two-year bonds at a record low yield of just 0.14 percent.
The strong result came as some high-profile investors had raised doubts over whether Europe's biggest economy could escape the impact of debt problems in Spain and Italy.
U.S. hedge fund manager John Paulson, who earned billions when the financial crisis struck from bets against the overheated U.S. housing market, on Tuesday told investors he was now shorting European sovereign bonds, two people familiar with his portfolio said.
The head of German life insurer Allianz Leben, Maximilian Zimmerer, told financial daily Handelsblatt that the safety of long-term German government bonds was overrated.
"They are overvalued; the yield is too low. If a euro zone country runs into trouble, Germany in any case will have to pick up the bill in the end," Zimmerer said.
In the currency markets, a shift in the tone of minutes from the Bank of England's last policy meeting in early April surprised investors.
The UK central bank signalled it was much more concerned that inflation, currently 3.5 percent, was likely to fall more slowly than it had previously forecast, due to higher oil prices, the risk of firms boosting profit margins and weak productivity growth.
The minutes also showed that a long-standing advocate of more quantitative easing on its policy making committee, Adam Posen, had dropped his call for more stimulus.
The news wrong-footed many investors and drove sterling to a 19-month high against the euro and a two-week high against the dollar.
European Central Bank policymaker Jens Weidmann also told Reuters in an interview there was no reason to discuss another round of liquidity injection into the euro zone banking system.
Two rounds of so-called long term refinancing operations (LTROs) in December and February had pumped more than 1 trillion euros into the system, easing fears of a debt crisis and sparking a rally in riskier assets like equities and the sovereign debt of Spain and Italy.
The euro was also under pressure by worries about Spain's fiscal and banking sector problems ahead of a planned debt sale on Thursday, when the government will sell fresh two- and 10-year bonds.
The Bank of Spain reported bad loans at domestic banks had risen to their highest level since October 1994 in February, to 8.2 percent of their credit portfolios, as the sector continues to battle sliding house prices and a looming recession.
The euro was down 0.4 percent at $1.3107, while the dollar measured against a basket of major currencies was up 0.4 percent at 79.81.
In equity markets, share prices edged lower, with banks leading the falls, but a strong start to first quarter earnings reports from the United States helped underpin the market. Around 75 percent of companies reporting so far have beaten analysts' estimates, according to Thomson Reuters data.
"If this can be maintained, it will be a good reminder and a timely reminder that while governments and individuals may be struggling, companies remain in good health," said Richard Hunter, head of UK equities at Hargreaves Lansdown.
The euro zone blue-chip Euro STOXX 50 index, which saw its biggest daily gain of the year on Tuesday, fell 0.2 percent at 2,422.92. The FTSE Eurofirst index of top European shares was down 0.4 percent at 1048.73.
In commodity markets the IMF's latest economic growth forecasts, which raised the global growth estimate to 3.5 percent from 3.3 percent in January, offered some support to offset the worries about the euro zone, but prices were generally weaker.
Brent June crude slipped $1 to $117.81 a barrel, while U.S. May crude fell 5 cents to $104.15.
Spot gold eased for a fourth straight day to be down 0.1 pt to $1,646.64 ounce after touching a one-week low near $1,634 on Tuesday.