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LONDON, Sept 17 (Reuters) - Weakness in European stocks on Wednesday capped a global equities recovery sparked by the U.S. government bailout of cash-strapped insurer AIG and interbank lending rates remained stubbornly high.

Oil jumped $3, government bond prices fell and the low-yielding yen came under pressure after the $85 billion rescue package for American International Group eased some of the fears gripping markets.

Better than expected results from Goldman Sachs and Morgan Stanley also helped, though the Federal Reserve kept rates on hold at its Tuesday meeting against some expectations of a cut.

Asian and U.S stocks gained sharply but European shares rapidly lost steam after an early rally, trading only 0.3 percent higher after 6 percent losses over the first two days of the week as overnight interbank dollar rates were indicated as high as 8 percent.

Shares in British bank HBOS, which has been the focus of funding concerns, plummeted more than 40 percent, but pared losses on a BBC report of a possible merger with Lloyds TSB. The two banks declined to comment.

"We've just bought some time, and the underlying problems still exist," said Justin Urquhart Stewart, investment director at Seven Investment Management.

"This is going to be a very tentative market."

The past week has changed the face of the U.S. banking sector. Lehman Brothers filed for bankruptcy protection and Merrill Lynch agreed on Monday to be bought by Bank of America for $50 billion.

"People are scared of further financial institution difficulty. Funding remains difficult and flows of risk-sensitive capital have slowed considerably," said Patrick Bennett, Asia foreign exchange and interest rates strategist with Societe Generale in Hong Kong.

TREASURIES FALL

However, U.S. Treasuries lost ground and the low-yielding yen fell against the euro, reflecting some easing in risk aversion.

Yields on the U.S. 10-year Treasury note climbed to 3.577 percent from 3.44 percent, and the yen, which is used to fund trades in riskier but traditionally higher yielding assets like equities, fell 1 percent against the euro.

Emerging sovereign debt spreads narrowed by 16 basis points to 400 basis points over U.S. Treasuries, after hitting their widest levels in nearly two years on Tuesday. Benchmark emerging equities rose 0.38 percent, after hitting October 2006 lows on Tuesday.

Commodity prices rallied, led by oil. November U.S. light crude futures rose $2.7 to $93.89 a barrel after hitting a seven-month low on Tuesday, supported partly by supply disruptions after Hurricane Ike crashed into the Gulf of Mexico.

(Additional reporting by Kevin Plumberg in Hong Kong and Carolyn Cohn in London; Editing by Ruth Pitchford) Keywords: MARKETS GLOBAL

tf.TFN-Europe_newsdesk@thomson.com

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