The fall was led by the gilts market, which suffered a rout, according to Nigel Richardson, head of bond research at Yamaichi International. Share prices suffered their biggest one-day fall since February last year with pounds 14.6bn wiped off the value of the stock market.
Sterling had a torrid day, falling close to its all-time low against a basket of currencies. Speculation mounted the Government might have to raise interest rates to protect its value.
After the initially favourable reaction to Mr Major's leadership gamble, the City was highlighting the potential risks. "The view in the markets is that Major's out," Mr Richardson said.
An early general election was seen as one possible outcome as the Conservatives tore themselves apart over Europe.
David Mackie, economist at JP Morgan, said: "The risk of a general election in the next six months has gone up."
The political worries were most apparent in the gilts market where the September long-gilt future dropped sharply by more than one and a half points. Ahead of the Bank of England's pounds 2.5bn auction on Thursday, the benchmark 10-year bond was down nearly one and a half points, rising to a yield of 8.36 per cent.
Mr Mackie said: "What you're seeing is political risk being built into the yields demanded on gilt-edged stocks." In his view, the leadership election had brought into sharp focus the shift in policy that had already occurred this year with Kenneth Clarke's loosening of the commitment to low inflation.
The clearest indication of the pricing in of political risk was apparent in the yield differential between gilts and German bunds. On Wednesday, the day before John Major stunned everyone with his extraordinary resignation as party leader, the gap stood at 1.55. It closed last night at 1.75, a widening of 20 basis points.
Market-makers savagely marked down stocks as Data stream estimated that pounds 14.6bn was wiped off share values on the London stock markets. The blue-chip FT-SE 100 index finished 70.2 points off at 3,309.2.
Yesterday's fall added to Friday's 24-point plunge, and is the biggest since 24 February 1994 when it lost 74.4 points.
Popular shares such as BT, down 10p, British Gas, down 10p, National Power, down 15p, and PowerGen, down 15p, joined in the decline by virtually every leading share.
The only consolation was that trading volumes were thin, with buyers staying on the sidelines.
Bob Semple, a UK equity strategist with NatWest Securities, said: "What the markets want is a decisive outcome. They don't want Mr Major scraping through - the issue will come back to haunt them in November.
"What's most important to the City is who is Chancellor. It would be bad for financial markets if Mr Clarke were to go."
Sterling came under heavy pressure in the foreign exchange markets, as foreign investors took fright at the sight of the turmoil among the Tories. "Sentiment is uniformly bearish among foreign exchange investors," said Neil Mackinnon, currency strategist at Citibank.
At the close of London trading, the pound had fallen two pfennigs compared with its Friday close against the mark and two cents against the dollar. Its rate against a basket of currencies dropped from 84.0 to 83.3, close to its all-time low.
Against this background, the City started to factor in a possible rise in interest rates to protect the pound. Liffe's September's short sterling contractdived to suggest a rise in rates of 20 basis points.Reuse content