THE old adage that one should always expect the unexpected in financial markets was borne out again yesterday. Before the Bundesbank Council departed on its annual vacation four weeks ago, expectations were very high that a rate cut would be delivered as a going away gesture, but, true to form, expectations were shattered.

At the beginning of this week the odd brave soul was prepared to concede that a cut was a possibility, but the release of the much stronger than expected Ifo survey of German business confidence on Wednesday forced most of these back below the parapet.

But, again, true to form, the Bundesbank delivered what can only be described as an aggressive cut of 0.3 per cent in its key money market repo rate. Yesterday's move has tremendous significance for European financial markets and sends a very profound message about the lengths to which the Bundesbank will go to ensure that EMU remains on the agenda.

Bundesbank president, Dr Hans Tietmeyer, justified the cut as a response to favourable trends in money supply growth, a lack of any inflation dangers and general economic conditions.

On the surface these explanations are plausible. Earlier this week money supply growth fell to 8.6 per cent, inflation is well below the Bundesbank's 2 per cent target and most economic indicators are suggesting that while the economy is on the road to recovery, it is still reasonably fragile.

However, in normal circumstances with rates at such low levels and economic recovery becoming established, rate cuts would probably not be deemed necessary by the traditionally conservative policy making firmament in Frankfurt.

These are not normal circumstances. The Bundesbank's action yesterday was primarily motivated by a desire to keep the EMU dream alive. The French franc has been coming under some pressure as fears grow that the government will not be able to deliver the politically unpopular but necessary fiscal measures to ensure that France will have some chance of meeting the Maastricht criteria.

The German currency has been an unwelcome beneficiary of this nervousness because without the French EMU would not happen and the deutschmark would rocket in value. After the experience of recent years, this is not something the Germans would desire.

The hand of friendship extended by the Bundesbank yesterday has allowed the Bank of France to cut interest rates and has alleviated some of the pressure for the moment.

However, the French will still have a difficult job delivering on the fiscal front against an economic background which can only be described as dire. The message is now clear that, if the French require further assistance down the road, the Germans will oblige once again.

This sort of behaviour would obviously be bad for the credibility of German financial markets, but then again the decision to allow the German currency participate in a single currency with a basket of mostly inferior products is not a credibility enhancing strategy in the first place.

From an Irish point of view, the latest developments in Germany are relatively good news but, with one month money continuing to trade above the key 5.5 per cent level, retail rate rises are unavoidable and the Irish Permanent led the way yesterday.

The Irish Central Bank is clearly of the view that the domestic housing market warrants higher interest rates, regardless of what messages are sent out about the EMU credentials of the pound. The upward move in Irish money market rates, which has given rise to the current round of retail rate increases, has resulted in a considerable widening of the Irish interest rate differential over all other `hard core' EMU aspirants.

Clearly the risk is that the current queries from foreign investors about why the differential is widening could result in a fundamental re appraisal of the real status of the pound.

On a more positive note, it is probable that the current round of retail rate increases will be the last for some time and we are not likely to be on the verge of an upward spiral. German rates may fall further but, if not, they will certainly remain down at current levels for a long time to come, as will be the case across the continent. Domestically, the strength of the pound will make sure that the current inflation illusion does not become a reality.