Analysts said the unsettled market conditions formed a poor background for decisions on further UK rate cuts at today's monetary policy talks between Kenneth Clarke, the Chancellor, and Eddie George, the Governor of the Bank of England.
The FT-SE 100 share index sank to 3,270.6, a loss of 57.5 points, while the price of government bonds slumped almost two full points.
In the US, Treasury bond yields rose to 6.79 per cent - the highest since the global bond rally began last summer - as fears mounted that the US Federal Reserve Board would be forced to lift the key Federal Funds rate to head off a resumption of inflation pressures.
Share prices on Wall Street were also badly hit but recovered from their lows, leaving the Dow Jones Industrial Average down 22.79 points at 3,809.23 by the close.
The US Commerce Department reported that the economy expanded at an annual rate of 7.5 per cent in the fourth quarter of last year - the fastest in almost 10 years.
The upward revision in the growth rate, from a provisionally reported 5.9 per cent, exceeded Wall Street's most optimistic forecasts.
The additional expansion was explained by a smaller trade deficit, which means that larger net exports will have added to economic growth. Consumer spending was also more robust than originally estimated. However, the figures showed that there was virtually no upward revision to inflation pressures during the quarter.
More worryingly, the February survey of manufacturing industry by the National Association of Purchasing Managers showed a smart pick-up in price pressures, the second month in a row in which prices rose sharply.
Gerald Holtham, chief economist at Lehman Brothers International, said: 'People must be concerned whether, after a period of delay, the US economy has launched into a traditional recovery, where growth rates of between 6 and 7 per cent in the first year are not uncommon.'
Mr Holtham and other analysts said the markets were expecting the Fed Funds rate - the leading market rate in the US - to rise to 4.5 per cent or more by the end of the year from 3.25 per cent now.
'Fed Funds could be over 5 per cent in 12 months' time. That is a very aggressive tightening and so it is no surprise that the market bloodbath continues,' said Neil McKinnon, chief economist at Citibank.
In Europe, bond and share prices also slumped after the Bundesbank cut the securities repurchase rate - the main market rate - by a miniscule 3 basis points, to 5.97 per cent.
Although the modesty of the Bundesbank reduction was not surprising in view of expectations of high money supply growth in January and still unresolved industrial wage negotiations, the markets were nevertheless rattled. Hopes receded that any dramatic declines in German rates lay in store.
German bund prices fell on concern over the Bundesbank's grudging attitude to lower rates, raising doubts over whether a DM3bn bond by the eastern German privatisation agency, the Treuhand, would be placed at all.
Similar interest rate worries plagued an Italian bond auction earlier this week.
They are prompting analysts to express concern at the heavy supply of bonds from European governments burdened by high budget deficits, which are forcing long rates up as bond prices fall.
Mr McKinnon said: 'The upward pressure on bond yields is bad for equities and bad for growth.' George Magnus, chief international economist of Warburg Securities, added: 'People are demanding a higher price for financing these deficits.'
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