German rate cut hopes tumble

Expectations of an early cut in German and US rates took a tumble yesterday with the release of data showing a rise in inflation in Germany and greater strength in the US economy. The news rattled the German bund markets, which fell back sharply and dampened the spirits of the US Treasury market.

Germany's regional inflation figures in June came as a real shock to the markets, which had been expecting a monthly increase of 0.1 per cent. Instead, consumer prices rose by 0.3 per cent in Hesse and Nordrhein-Westphalen and by 0.5 per cent in Baden-Wurttemberg.

If these figures were repeated at the national level, the year-on-year inflation figure would jump to 2.5 per cent from 2.2 per cent in May, Stephen King, economist at James Capel, calculated. This would move inflation sharply away from the 2 per cent rate the Bundesbank targets.

Analysts pointed out that the underlying rate of inflation remained subdued. The upturn in Baden-Wurttemberg was concentrated in erratic items like food, fuel and personal goods; these may unwind in the months to come. Julian Jessop, European economist at HSBC Markets, believed there was "still a fighting chance" therefore that inflation will fall back to under 2 per cent in coming months.

But there was general agreement among economists that the figures put a severe dampener on the prospect of an early cut in interest rates by the Bundesbank when its council meets next week.

This was the interpretation reached by the markets, which saw German bunds retreat sharply. The September bund future was down 83 basis points at 93.97, while the yield on the benchmark 10-year bund rose from 6.64 to 6.79 per cent.

In the US, durable goods orders rose 2.5 per cent in May compared with April against a consensus expectation of stagnation. This was the first rise since January and the largest gain since November 1994, according to the US Commerce Department.

Although the department also revised the fall in April in orders from 4.0 to 4.5 per cent, the largest drop since December 1991, the figures disappointed Wall Street.