The growing danger that the United States government will have to default on its $4,900bn debt for the first time in its history set alarm bells ringing in the financial markets yesterday.
The dollar fell to just above 100 and US Treasury bonds declined for the second day in succession, retreating from their best levels for nearly two years.
Share prices also fell on Wall Street yesterday after setting a record on Thursday. The pound, gilts and shares in London all ended lower in the wake of of these transatlantic jitters. Robin Marshall, chief economist at investment bank Chase Manhattan, said: "It's going to get worse before it gets better. Foreign investors could start selling dollar assets on a large scale."
Further weakness in the Mexican financial markets yesterday after the peso's recent slump also weighed on the US currency.
The conflict between President Bill Clinton and the Republican-dominated Congress over how to reduce the US budget deficit came no closer to resolution yesterday.
The President said he would veto a congressional bill to increase the debt limit because it had attached unacceptable spending restrictions. The ceiling will be breached on Wednesday, with more than $100bn in bills due for repayment.
Robert Rubin, US Treasury Secretary, said: "We can work our way through this for some period of time." But the markets are no longer confident that a last-minute deal on the deficit can be reached fast enough to avert a debt default.
Adrian Cunningham, an analyst at UBS, said: "Investors still do not think the US will default because it would have such severe ramifications, but the risk has increased measurably." Previously, the market view was that the small danger of default was outweighed by the benefits of a lower US budget deficit in future.
Even a temporary failure to repay principal or interest on Treasury bonds would have severe consequences.
Many investment funds have covenants that forbid them to hold the assets of any borrower who has ever defaulted, and would have to divest their holdings of US bonds. Credit rating agencies might also decide to downgrade the US government's rating.
The dollar fell to 100.57 in London compared with the previous close of 101.6. The US currency has lost 3 per cent of its value against the yen in the past five days. The yield on the benchmark 30-year Treasury bond had risen to 6.33 per cent from 6.25 per cent by late morning, when the Dow Jones industrials index was 18 points lower at 4,846.
The pound closed at DM2.2180, down from DM2.2353. The FT-SE 100 index lost 18.2 to end at 3523.4.