''What bond markets are worried about is that incumbent governments, with the exception of Chancellor Kohl's administration, will try to buy their way back into the reckoning by loosening fiscal policy in the form of tax cuts or higher public spending,' said Mark Tinker, of James Capel.
Worries about Labour's growing popularity led British markets to brush aside better-than-expected figures on factory gate prices. The long gilt future sank by more than 11 2 points, depressing the FT-SE 100 index by more than 45 points at one stage. The index of leading shares finally closed down 39.6 points at 3,016.3.
Trading volume was low at 487.3 million shares compared with a recent average of 650 million. Footsie hit a low point for the year of 2,931.9 on 1 June after falling 17 per cent from its peak of 3,520.3 on 2 February.
Despite a slight increase of 0.1 per cent in factory gate prices last month, markets seized on an unexpectedly sharp increase of 0.9 per cent in industry's raw material costs as evidence of rekindling inflation pressures. The rise reflected the recent surge in commodity prices and left raw material costs unchanged in the year to May. This represented a worsening of more than three percentage points since the turn of the year.
In January, industry's raw material costs stood 3.3 per cent below their levels a year previously.
As a result the markets ignored the fact that factory gate prices, excluding volatile prices for food, beverages, tobacco and petroleum products, were up by just 2 per cent in the year to May - the lowest rate on this basis since November 1967. On the same basis, factory gate prices rose at an annualised rate of just 1.1 per cent in the latest three months.
Kevin Gardiner, of Morgan Stanley, said: 'We have seen the best of cost-led disinflation. Manufacturers will first squeeze margins but later they will attempt to pass rising costs on to consumers, and they are likely to succeed.'
Higher raw material costs fanned fears that April's average earnings figures, out tomorrow, would show a rise to 4.25 per cent in annual earnings growth compared with 4 per cent in March.
Like other European markets, London was unnerved by fears that the Government might attempt to revive its popularity with tax cuts despite a large public sector borrowing requirement.
Falling French bond prices sent the CAC-40 share index 42.76 points lower to finish at 1,977.66. In Frankfurt, moderate losses in the German bund market pushed the DAX index down 27.3 points to a closing 2,105.78.
The bearish mood in global bond markets was initially touched off by worries that the US Federal Reserve might soon move to raise short-term rates. Susan Phillips, a Fed governor, warned there were slight signs of inflationary pressures in the US economy, especially in commodities.
The US bond market was also worried that today's US consumer prices might contain evidence of rising inflation pressures.
Bond markets, worried about the increased future supply of government debt needed to finance higher budget deficits, have been moving to offset the prospect of slacker fiscal policy by pushing up long-term interest rates and so, in effect, tightening monetary policy.
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