Worries that John Major was facing his worst leadership crisis pushed down sterling at the opening and led to early losses in gilt and share prices.
Gilts opened a point lower on adverse press speculation over the Prime Minister's future while share prices, also reacting to a steep fall on Wall Street on Tuesday night, dropped 46.5 points in morning trade.
The money markets defied most economists' predictions of unchanged or even lower base rates. They gambled that political turmoil would undermine the pound and push up base rates a quarter point to 5.5 per cent by June, and above 6 per cent by the year-end.
Sentiment changed after the Bank of England announced that its first auction of floating rate gilts since 1979 had gone well. The Bank issued pounds 2.5bn of the stock, due 1999, and the issue was oversubscribed 2.28 times.
In volatile trading conditions long-dated gilt prices swung from a 1-point loss to a gain of nearly 1.5 points. By the close, however, gilts rallied sharply, recovering more than 3 points from the day's lows and about 2 points on the day.
Ian Shepherdson, of Midland Global Markets, said long gilts became attractive after yields rose above 8 per cent and, while he was loath to call an end to market volatility, 'this was a very encouraging day'.
After opening a pfennig lower, sterling finished little changed at DM2.4837. However, more pronounced weakness against the dollar left sterling 0.4 points down at 79.4 per cent of its 1985 value against a basket of currencies, the lowest finish since 6 June last year.
John Sheppard, of Yamaichi, the Japanese securities house, said the City was worried that overseas investors would react badly to any further political upheaval and sell sterling, which would weaken all UK financial markets.
The early crisis atmosphere yesterday morning put paid to scattered hopes that Kenneth Clarke, the Chancellor, and Eddie George, the Governor of the Bank of England, would sanction a rate cut at their monthly monetary meeting.
Rumours that a rate increase might be announced were fuelled by reports that the monetary meeting had been delayed from 9.30 until midday. But the Treasury said there was no significance in the delay which was due to a rescheduled Cabinet committee meeting Mr Clarke had to attend.
Analysts said that the Chancellor would need a good set of inflation figures and indications that next week's tax increases were weakening consumer demand before he could justify another cut in rates. But most dismissed money market expectations of a near 1-point climb in rates by the end of the year.
The Treasury's monthly monetary report also helped to soothe sentiment in the gilt market. The Treasury said that, despite the fact gilt market inflation expectations rose by 0.5 per cent to around 4.5 per cent, inflation pressures remained weak.
It pointed to low producer price figures and lower independent inflation forecasts while CBI price expectations were still subdued.
The Treasury report added that despite mixed signals in the official figures, the recovery was continuing. Though retail sales fell back in February the trend was still upwards, manufacturing output rose sharply in January and CBI output optimism remained strong in March. Against that, car production appears to be on a downward trend despite a slight recovery in February, the Treasury said.
Elsewhere, there was little reaction to a 4-basis-point reduction in the German securities repurchase rate, to 5.76 per cent, confirming the gradual pace of German rate cuts. In the US, a 1 per cent fall in February factory orders, the first for seven months, did nothing to dispel expectations of continued strong growth.
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