(Bloomberg) -- Government bonds rallied after a deal to quash the looming crisis of confidence in Credit Suisse Group AG failed to assuage concerns that stress in the banking system could spread.

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Shorter-maturity bonds led the surge as investors bet that central banks would be more cautious in the face of strains in the banking sector. The US and German two-year yields dropped over 20 basis points, while the US 10-year yield slumped to the lowest since September.

At the forefront of investor reaction was a continued debate as to what will happen at the Federal Reserve’s rate decision this week, with the lack of consensus adding even more uncertainty to the market. Global stocks and equity futures mostly slid, while a section of Asia’s bank bond market slumped by a record after the wipe-out of Credit Suisse Group AG’s so-called additional tier-one notes.

Regulators worldwide rushed to shore up market confidence over the weekend, with the Swiss government brokering a rescue deal of Credit Suisse Group AG and six central banks unveiling plans to boost dollar liquidity. The market reaction suggested traders were far from being convinced the rescue measures are sufficient to restore global investor confidence.

“Many will be wondering who could be next,” said Rodrigo Catril, a strategist at National Australia Bank Ltd. in Sydney. “Central banks need to instill confidence without given a message of concern.”

What was most damping risk sentiment Monday was concerns over global banks’ additional tier 1 bonds, after a Swiss regulator said $17 billion of such notes from Credit Suisse will be wiped out.

“You have a marked re-pricing of a sizable chunk of banking sector credit” after the write down in AT1s, said Philip McNicholas, a strategist at Robeco in Singapore. “That has started to percolate through to equities and triggered a broader risk off tone and a flight to safety.”

US overnight indexed swaps now see a 60% chance of a quarter-percentage point hike at this week’s Fed meeting, up from the 50% odds penciled in during the middle of last week. For the European Central Bank, money markets imply rates peaking at 3.16% by July compared to 3.23% on Friday.

“A widespread perception of ongoing, significant banking risks is likely to give the Fed pause in its plan to raise rates,” said Jason Schenker, president of Prestige Economics.

German two-year yields dropped as much as 29 basis points to 2.10%, while US equivalents fell as much as 21 basis points to 3.63%.

Markets are likely to remain nervous even after UBS agreed to buy Credit Suisse, said Andrew Ticehurst, a rates strategist at Nomura Holdings Inc. in Sydney. “That said, we are only at the start of what could be a long and wild week, and markets are likely to remain on edge for some time.”

Two-year US yields swung between 3.71% and 4.53% last week, the widest weekly range for the interest-rate sensitive benchmark since September 2008. The widely-watched MOVE index, which measures implied volatility in Treasuries, topped out at 199 points on Wednesday, the highest since the global financial crisis in 2008.

“Recalibration of risk sentiment should see some big swings as well and I don’t think we’ll settle into a new trading range until perhaps after this week’s FOMC,” said Jessica Ren, a fixed income strategist at Westpac Banking Corp. in Sydney. “Price action will continue to be more sensitive than usual to headlines.”

--With assistance from Ruth Carson, Masaki Kondo and Libby Cherry.

(Updates with moves and context throughout.)

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