The shock led to a 38.3 point fall in the FT-SE 100 index to 3,485, the first time it had closed below 3,500 since the end of August. The benchmark 10-year gilt yield rose to its highest level since mid-August.
Turbulence followed in other financial markets. Bond and share prices fell sharply in Europe and America, taking weak currencies like the dollar, pound and lira lower.
``It was the worst gilts auction result ever in this country,'' said Andrew Roberts, an analyst at investment bank UBS. A Bank of England spokesman said the result was disappointing, but pointed out that nearly all the stock - pounds 2.967bn out of pounds 3bn - was sold.
Gloomier views about how much the Government will have to raise to finance its borrowing requirement this financial year helped explain the flop. The Treasury's forecast the public sector borrowing requirement at pounds 23.6bn this year, but this will certainly turn out to be an underestimate.
Gilts analysts estimate that a higher PSBR, of pounds 28-32bn, will require gilts sales of pounds 18-22bn before the end of March. This might mean that an extra auction will have to be squeezed in. On Friday the Bank of England is due to announce the schedule of gilts to be supplied during the next quarter.
Yesterday was the first time ever that ``cover'' in the auction was less than 1.0, meaning demand for the stock was less than supply. The gap between the average and lowest price paid - the "tail" - was an unusually big seven basis points.
``This has been a very strong message from the City to Whitehall that big tax cuts are not on the cards,'' said Stephen Lewis, director of research at the London Bond Broking Company.
Analysts also blamed the recent turbulence in international markets for yesterday's gilts flop. The British auction was sandwiched between two disappointing auctions of US Treasury bonds. On Tuesday and Wednesday both demand for the $30bn-worth of short-term Treasury bonds up for auction and prices were far lower than expected.
Kevin Adams at BZW said: ``Financial markets have been extremely volatile." Simon Briscoe at Nikko Securities said: ``International investors have had a lot on their minds." Currency and bond markets have been in a state of uproar due, in part, to doubts over the future of European Monetary Union and dissatisfaction with Japan's supplementary budget.
Markets are also reassessing the outlook for inflation after a brief period of optimism that economic growth had slowed enough for interest rates in the US and UK to fall. New orders for durable goods in the US rose 4.9 per cent last month, the biggest increase in a year. Other recent figures have suggested that US growth is picking up.
The yield on the 10-year benchmark gilt rose to 8.10 per cent, and on the benchmark US long bond jumped to 6.64 per cent. The Dow Jones index opened more than 20 points lower but regained all but three points by the close. The dollar dipped below 100 and DM1.4220 before recovering. The pound lost nearly two pfennigs, closing at DM2.2442. Its index against a range of currencies fell 0.5 to 84.2.
The mark also rose against the lira, peseta, French franc and Swedish krona. But the German stockmarket saw the biggest fall amongst the Continental markets.