Strong economic data from the two largest eurozone economies on Thursday, and a strike threat by German workers for higher pay, added to the case for another European Central Bank rate rise to curb inflation.
Data showed German consumer sentiment was set to improve more than expected in May on falls in unemployment and hopes of wage rises, while French business confidence jumped to its highest level in six years in April as foreign orders rose despite the strength of the euro.
European bonds slid as investors took the view that an ECB rate hike to 4.0 percent was inevitable given healthy growth and fears bigger wage demands could spell a pick-up in inflation. "We had strong Ifo yesterday and then continued the strength with the Gfk numbers and French business confidence," said Elisabeth Afseth, fixed income analyst at Evolution Securities.
Gfk market research group's forward-looking German sentiment indicator rose to 5.5 for May from 4.4 for April, after an unexpectedly higher reading of Germany's Ifo business sentiment index on Wednesday.
French business morale rose to 111 in April from 109 the previous month, national statistics office INSEE said - the highest reading since March 2001 - suggesting companies have adapted to a strong euro. The data painted a surprisingly strong picture of the French economy ahead of the presidential election run-off on May 6 and could benefit the ruling UMP's candidate Nicolas Sarkozy.
"It just shows that French industry will have another year of growth in 2007 despite all the comments about it losing speed," said Alexander Law, economist at Xerfi. Gfk's survey showed a fourth straight rise in income expectations to a six-year high at 29.6 in April from 15.9 the previous month, showing expectations of higher wages have leapt.
Workers in Germany's engineering and metal-working sector are threatening to strike next week after failing to agree on a new pay deal with employers in key state North Rhine-Westphalia. IG Metall, Germany's biggest union, has demanded a 6.5 percent raise for its 3.4 million workers but employers have so far only offered a fixed pay increase of 2.5 percent, plus a one-off payment equivalent to a 0.5 percent rise.
The union has rejected this and analysts expect it to secure a rise in excess of 4.0 percent after years of exercising wage restraint - something the ECB is still urging. Productivity gains mean the wage increase could be even higher. German Finance Minister Peer Steinbrueck said the German economic upswing had been sufficiently strong to weather a rise in value-added tax, contrary to expectations.
"It was generally expected that the higher VAT rate would lead to a dip in the first quarter. This has not happened. The economy is buoyant and has probably only experienced a minor slowdown," Steinbrueck told a Euromoney conference in Berlin.
Public perception of an improvement in the business climate will make holding wage claims back much harder and the ECB's requests for restraint less likely to be heeded.
There was also upbeat news from Spain, the fourth largest economy in the eurozone. Retail sales hit their fastest growth rate in four years in March, up 5.7 percent, shrugging off rising interest rates and slower house price gains.