The Dow Jones average plunged 130 points, or 2.5 per cent, at one stage as the market took comments from the US Federal Reserve chairman, Alan Greenspan, to mean that further interest rate cuts were now unlikely.
A recovery in late trading left the Dow Jones average 57.41 points off at 4,628.87 at the close, taking the two-day fall to 107.53 points.
Nick Knight, equity strategist at Nomura, said he thought a 100-point fall in New York could translate into a 50-point fall in London if Far Eastern markets also reacted badly to Wall Street's slump. He said: "It was only a matter of time before equities reacted to the backing up in bond yields."
Mr Greenspan told Congressmen yesterday that inflation in the US had improved faster than expected and that the maximum danger of recession had passed.
The financial markets took this cheerful message as a sign that the chance of further interest rate cuts had diminished.
The fall in share prices was exacerbated by further profit-taking on technology stocks such as IBM, Microsoft and Intel.
The price of the benchmark 30-year Treasury bond fell about half a point.
Michael Metz, strategist at Oppenheimer & Co, said: "My guess is that we are seeing the beginning of a correction. There have been numerous warnings from corporations that the third quarter will be difficult."
Grace Messner, vice-president in charge of equity management at Wilmington Trust, said the correction was expected, but added that the market was entering a new phase.
"The market as a whole is entering a new environment in which the economy is starting to grow faster," she said.
"And just as slower growth was good for the market, growing at a faster rate might not be so wonderful. We are moving into a period of higher risk," she said.
But William Dodge, chief strategist at Dean Witter Reynolds, pointed to a fundamental anomaly in the market's reaction. "On the one hand, the economy is too strong for the bond market and on the other, earnings concerns are sending technology stocks down. One of these things has got to be wrong."
Mr Greenspan, in his twice-yearly Humphrey Hawkins testimony, described the outlook for the US economy as encouraging. Inflation was "less worrisome" than earlier in the year.
A recession could not be ruled out, but he said: "We may have passed the point of maximum risk."Reuse content