Oil rises, but stocks sputter on Fed jitters

An investor reads a newspaper in front of an electrical board showing stock information at a brokerage house in Huaibei, Anhui province September 19, 2011.

NEW YORK (Reuters) - Expectations that the Federal Reserve will act to boost the U.S. economy drove up oil prices on Tuesday, but equities lost steam on caution over what the Fed will actually announce when its policy meeting ends on Wednesday.

Wall Street gave up gains of about 1 percent heading into the close as a wary mood gripped the market following the overnight downgrade of Italy's credit rating by Standard & Poor's.

The Fed is expected to unveil a program to buy longer-dated bonds in a bid to keep already-low, long-term interest rates low, if not lower, in a move known as Operation Twist when its two-day policy meeting ends on Wednesday.

"A lot of people are expecting more out of the Fed than they are going to get -- they are going to get the twist, they are not going to get a QE3," said Ken Polcari, managing director at ICAP Equities in New York.

Polcari referred to two previous Fed bond-buying programs known as quantitative easing.

The expected new Fed program would further ease U.S. monetary policy, a move that left bond traders anxious considering the European debt crisis is far from being resolved.

"When you have the (Fed) basically getting ready to talk about buying more and longer-dated debt, who wants to bet against them being successful in bidding prices up," said David Dietze, chief investment strategist at Point View Financial Services in Summit, New Jersey.

Taking into account gloomy economic news in the United States, equity prices faded and safe-haven government debt rose by the end of the session.

The government reported that U.S. housing starts were down more than expected in August and the International Monetary Fund said U.S. growth would be "modest relative to historical averages for years to come."

"From a bond investor's perspective, there is still tremendous pessimism on the fundamentals," said Dietze.

The Dow Jones industrial average .DJI closed up 7.65 points, or 0.07 percent, at 11,408.66. The Standard & Poor's 500 Index .SPX fell 2.00 points, or 0.17 percent, at 1,202.09. The Nasdaq Composite Index .IXIC declined 22.59 points, or 0.86 percent, at 2,590.24.

Bond prices turned higher at the end of a see-saw session.

Benchmark 10-year Treasury notes traded 6/32 higher in price to yield 1.94 percent. ,

Equity trading volumes both in the United States and Europe were lighter than usual, a sign investors were cautious before the Fed's meeting ends on Wednesday.

Earlier in Europe, stocks closed up 2 percent, with big-dividend-paying defensive stocks pushing gains.

MSCI's all-country world equity index .MIWD00000PUS rose 0.4 percent.

Brent crude bounced back a day after suffering heavy losses, partly on expectations U.S. inventory data will show a drawdown in stockpiles.

In London, Brent crude settled up $1.40 at $110.54 a barrel.

The U.S. crude contract for October, which expired at the close, settled up $1.19 at $86.89 a barrel. The more heavily traded November contract gained $1.11 to settle at $86.92 a barrel.

The euro also traded mostly flat against the U.S. dollar over concerns about Standard & Poor's credit downgrade of Italy's debt and Greece's ability to avoid default.

Also weighing on the euro was data showing German investor sentiment dropped to its lowest level in nearly three years.

The euro was up 0.02 percent at $1.3676.

Gold headed for its biggest daily gain in a week as Italy's credit downgrade and speculation of more U.S. stimulus drove bullion as a safe-haven.

Gold futures for December delivery, the most active contract, settled up $30.20 at $1,809.10 an ounce.

(Reporting by Claire Sibonney, Ellen Freilich, Angela Moon and Nick Olivari in New York, Marius Zaharia and Ikuko Kurahone in London and Harro Ten Wolde in Frankfurt; writing by Herbert Lash; Editing by Leslie Adler)