The FTSE 100 index leapt more than 123 points to 4,728.0, in its second biggest one-day rise on record. It was the largest gain in share prices since the recovery from the 1987 stock market crash. Meanwhile, the pound slipped back from its overnight high of DM2.91 to end at just under DM2.89. Its index against a range of currencies fell by 0.5 to 101.6.
Pre-Budget speculation that Gordon Brown will deliver tax increases designed to dampen the budding consumer boom accounted for the stock market euphoria, analysts said. This would reduce the pressure on the Bank of England to cool the economy by increasing base rates again.
Steve Wright at BZW said: "This was the last thing you'd expect before a Labour Budget." But the market was reacting to rumours that Gordon Brown would target consumers with much higher taxes, he said.
Many experts have been calling on the Chancellor to get tough in his first Budget because rising interest rates have helped drive the pound to an uncomfortably high level.
But even as the financial markets concluded that the "Iron Chancellor" would live up to his reputation by targetting the housing market and raising "green" and "sin" taxes, Britain's biggest mortgage lender warned him that the housing market was not booming.
Halifax reported that house prices climbed 0.7 per cent in June, to a level 7.1 per cent higher than a year ago. This was far tamer than separate figures last week from Nationwide. Halifax said: "There is no need for any specific Budget measures aimed at curbing an allegedly `booming' housing market."
The latest business survey yesterday, of purchasing managers in manufacturing, suggested the strong pound has not yet harmed output or exports. But it has almost certainly hit profit margins on export business.
Peter Thomson, director general of the Chartered Institute of Purchasing and Supply, said: "It is encouraging that exports have not yet been hit by the pound. What is left of British industry is a good deal more efficient than it used to be."
But Robert Barrie, chief economist at BZW, said: "Right across the economy profit margins are under pressure. Companies are finding it hard to make money." Relief from the strong pound was urgently needed, he warned.
Most economists have been predicting only modest tax increases, amounting to less than pounds 5bn, on top of the windfall tax on privatised utilities. Yesterday these expectations had been revised up, with the City now expecting a rise in the tax burden big enough to make a difference to the interest rate outlook.
Analysts warned that the markets would fall in an equally dramatic fashion if these new expectations were disappointed.
"The stock market would be very much disappointed if Gordon Brown doesn't deliver now," said Mr Wright. A warning signal was the fact the gains have been concentrated on a relatively small number of stocks, he said.
Since the start of this year five shares - HSBC, Glaxo Wellcome, Lloyds TSB, Shell and SmithKline Beecham - have accounted for nearly 60 per cent of the rise in the FTSE 100.
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