Bonds weaken as shares sparkle: Positive inflation figures boost London equities but investors fear end of Europe's low-interest climate

FEARS that the trend of falling European interest rates may be coming to an end drove down European bond prices and erased gains in gilt-edged prices set off by sparkling British inflation figures.

But the bright domestic economic news lifted London share prices, with the FT-SE index of 100 leading shares ending the day 43 points higher at 3,190.3, a shade below the day's best levels.

The fall in European bond markets, led by German bunds, came despite speculation that the Bundesbank may cut key interest rates today, when its policy-making central council meets for the first time since the summer recess. Whether the Bundesbank lowers rates today or later, analysts said the markets were already concluding that the next cut in the discount rate, now 4.5 per cent, may be the last one. John Shepherd of Yamaichi said: 'When do they go up? That's going to be the story.' Jouni Kokko, of Warburg Securities, added: 'If we get a rate cut it will be the last one, and the next one will be up, so it's bearish.'

The Bundesbank is thought to be anxious to act well before the German federal elections in October.

Bund prices dropped almost a point from the day's highs to end half-a-point below the previous day's close. As a result, gilt-edged securities in London gave up gains of more than a point to end little changed on the day. French, Italian and Belgian bonds all faltered after the move to dump German bunds. The setback for gilts came despite a 0.2 point fall in underlying inflation to 2.2 per cent last month - the lowest for 27 years.

Analysts expressed surprise that the positive economic news in Britain was overshadowed by European sentiment. Gilts failed to draw support from the prevailing view that a rise in base rates looks unlikely as long as the inflation picture remains encouraging.

Fading expectations of an autumn rise in base rates slowed the pound's rise following yesterday's economic figures. Sterling ended less than half-a-pfennig higher at DM2.4001 and against a basket of currencies was unchanged at 78.8 per cent of its 1985 value.

European bond markets were also worried about the size of budget deficits. In addition to deepening worries about the scale of Italian and Scandinavian bond issues to come, analysts estimated the Bundesbank had disposed of only 10-15 per cent of the DM100bn ( pounds 41.6bn) it needs to sell this year. Warburg's Mr Kokko said: 'The markets have become really obsessed with funding.'

Gloom in Europe was fuelled in part by Tuesday's half-point increase in leading US rates.

Analysts said it underlined uncertainty over European rates after growth projections in Germany and France were revised upwards.

The rise in US rates triggered a rally in US Treasury bonds on Tuesday night but signs of a significant upward move were absent yesterday. The yield on the benchmark 30-year bond was about 7.35 per cent. Wednesday's rally sent the yield tumbling from 7.48 per cent to 7.36 per cent.

Senior US officials yesterday welcomed the fall in long-term US rates, following the increase in short-term rates, as an endorsement of the US Federal Reserve's anti-inflation policies.

Lloyd Bentsen, the US Treasury Secretary, said: 'I think you had a good reaction out of the long-term rates.'

Growth would persist, Mr Bentsen said, with inflation under control.

Despite the increase in US rates the dollar failed to rally and ended the day slightly higher at DM1.5575.

The US currency appears fundamentally weak, with market operators and some Far Eastern central banks reported ready to sell at the slightest sign of a rally.