U.S. 2-year yields fell to their lowest since mid-May after the Wall Street Journal posted an online report saying Freddie Mac executives were in meetings with Treasury officials on Wednesday and "may explore whether the Treasury could clarify its intentions in a way that would reassure investors."

Meanwhile, Minneapolis Fed President Stern said in an interview today that the government cannot let Fannie and Freddie fail. But market participants believe the common equity holders won't be part of that bailout.

Shares of Freddie Mac closed down $0.93, 22%, to $3.24 while shares of Fannie Mae were down 1.61, or 27%, to $4.40.

"The bond market traded with a very focused flight-to-quality bid resulting in a steeper curve and closes at new highs. The reason? Stocks. More specifically, Freddie's and Fannie's trouncing amidst speculation (or anticipation) that a government takeover is around the corner and shareholders will be left with nothing," wrote U.S. government bond strategist at RBS Greenwich Capital in a research note.

U.S. two-year yields were down 5.0 bps to 2.25%, with five-year yields down 4.8 bps to 3.01%, 10-year yields down 3.2 bps to 3.80% and 30-year yields down 1.5 bps to 4.45%. The Eurodollar March 09 contract was up 8.0 ticks to 97.09. The yield curve was steeper, with the 10/2-year spread up 1.5 bps to 155.05 bps.

The worries about Fannie and Freddie didn't spread to the wider financial sector, and that helped U.S. stocks closed higher.

The Dow Jones industrial average closed up 69 points to 11417, the S&P 500 closed up 8 points to 1275 and the Nasdaq closed up 5 points to 2389.

Stocks of oil sands companies were also boosted by reports that Warren Buffett and Bill Gates had recently visited Fort McMurray, Alberta.

In Canada, an equity markets surge was led by energy stocks. Toronto's S&P/TSX composite index closed up 286 points to 13350.

WTI crude oil was up $1.72 to $116.26.

The rally in crude came despite a U.S. Energy Information Administration report showing that crude stockpiles increased 9390k barrels in the week ending Aug. 15, the largest build in crude since March 2001.

"In light of the 'reversals' to the upside in so many of the energy and energy related markets yesterday, the time has come to be bullish of energy," wrote commodities trader Dennis Gartman in his trading letter.

Canadian markets also reacted to the June report on retail sales. Sales excluding autos rose 1.4% in the month, overshooting the 0.6% expected. Total sales were in line with estimates at 0.5%.

"The headline looked great but if you scratch below the surface it's not so great," said Carlos Leitao, chief strategist and economist at Laurentian Bank.

Leitao said the gains in sales were due to price increases, and total sales volumes declined 0.4%.

Yields on two-year Canadian government bonds were up 5.7 bps to 2.80%, with five-year yields up 3.5 bps to 3.10%, 10-year yields up 1.5 bps to 3.58% and 30-year yields up 1.4 bps to 4.03%. The December 08 BAX contract was down 3.0 ticks to 97.11.

In Germany, returns on two-year German bonds were up 1.9 bps to 3.99%, with five-year yields down 0.7 bps to 3.96%, 10-year yields down 4.2 bps to 4.12% and 30-year yields down 5.2 bps to 4.58%.

Yields on UK two-year bonds were down 0.7 bps to 4.55%, with five-year yields down 1.2 bps to 4.49%, 10-year yields down 3.1 bps to 4.56% and 30-year yields flat at 4.42%.

The Canadian dollar was down 0.0002 to 0.9421 against the U.S. dollar (1.0615 USD/CAD) and up 0.09 to 103.46 against the yen.

The U.S. dollar was up 0.08 to 109.81 against the yen and the Dollar Index was up 0.085 to 76.924.

The euro was down 0.0032 to 1.4744 against the U.S. dollar, down 0.0033 to 1.5649 against the Canadian dollar, up 0.0008 to 0.7921 against the pound sterling and was lower by 0.22 to 161.90 against the yen.

The pound sterling was down 0.0058 to 1.8614 against the U.S. dollar and down 0.0061 to 1.9758 against the Canadian dollar.

On Thursday, inflation figures will be revealed and the Bank of Canada core consumer price index is expected to rise to 1.6% in July from 1.5% the month prior.

Leitao said the risk is for a higher number because gasoline prices have remained high, despite a pullback in crude prices.

"People are rethinking the view that inflation is no longer a problem," he said.

All data taken at 4:10 p.m. EDT.

By Adam Button, This email address is being protected from spam bots, you need Javascript enabled to view it , edited by Megan Ainscow, This email address is being protected from spam bots, you need Javascript enabled to view it

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