The pound rose by 2.1 pfennigs to close at DM2.4868, its highest since mid-January. It gained about 1.25 pfennigs following the unemployment figures - showing falls in jobless totals throughout the country - and pushed through DM2.48 on the German move. Against a basket of other currencies, the pound gained 0.6 points to close at 80.7 per cent of its 1985 value.
The markets were surprised by the Bundesbank's decision to cut its discount rate - the floor for market rates - by a quarter-point to 7.25 per cent. Prospects for a rate cut were thought to have receded following poor German money supply figures on Wednesday, which showed the broad measure M3 growing at 3.2 per cent in the year to March. The Lombard rate - the ceiling for market rates - was cut from 9 to 8.5 per cent.
Sterling's strength reflected the belief that the gap between German and British rates - which narrowed yesterday to 1.25 percentage points - is set to shrink further in coming months. Avinash Persaud, currency analyst at UBS, said the prospect of further rate cuts in Germany suggested that the pound could rise to DM2.60 in the next 12 months.
The German rate cut prompted reductions in Belgium, Denmark, the Netherlands, Austria and Italy, with the French also expected to follow suit next week. But the Treasury quickly poured cold water on hopes of a rate cut in Britain, arguing that the current 6 per cent base rate was consistent with recovery. Fears of inflation - accompanied by the growing belief that economic recovery in Britain may turn out stronger than expected - saw gilts prices drop on the unemployment figures, recovering some ground after the announcement of the German rate cut. The markets are becoming increasingly convinced that another cut in British interest rates is unlikely, and that the next move may be up. The 9 per cent stock due 2008 fell by pounds 7 32 to pounds 10527 32 , while the benchmark five-year bond now yields more than 7 per cent.
The cash and futures markets in German government bonds and other German securities were hit at lunchtime by incorrect news agency reports that the Bundesbank had left rates unchanged. Liffe said the market's trading mechanism coped with the swings. 'But when there are violent swings members are significantly affected,' a spokesman said.
Long-dated gilts prices were helped by average earnings figures, which suggested that inflation was unlikely to be a problem in the short term. Average earnings rose at an underlying rate of 4.5 per cent in the year to February, down from 4.75 per cent in the year to January.
Earnings growth has been depressed by falling pay settlements, which are now running below 3 per cent. Settlements in February included the laundry workers' wages council, at 2.41 per cent, down from 4.49 per cent last year. Earnings growth slowed from 5.25 to 5 per cent in manufacturing and from 4.5 to 4.25 per cent in services.
The combination of rising output and falling employment saw productivity growth in manufacturing accelerate to its highest rate in nearly six years. Output per person employed in the three months to February was 7.2 per cent up on a year earlier, the biggest rise since April 1987.
Rising productivity and slowing earnings growth saw the amount paid in wages and salaries to produce each unit of output drop 2 per cent in the year to the three months to April. This fall in unit labour costs - a key measure of international competitivenesss - was the largest since the measure began in 1970.