Sterling lost three pfennigs against the German mark, closing at DM2.2323, its lowest for a month. It was weak against a range of other currencies. Sterling's trade weighted index finished the day at 83.6, compared with Friday's close of 84.3.
The FT-SE 100 index ended nearly 27 points lower at 3,744.3 and gilts lost more than a point.
High on the list of explanations for the turmoil was the risk of further political fallout from the Scott Report, including the possibility of a rebellion on the eConservative backbenches. The latest IRA bomb in London also unsettled international investors.
Shares were affected too by a fall in Japan's Nikkei 225 index, down nearly 82 points to 20,721.25 following Friday's drop on Wall Street.
However, political concerns were a gloss on an underlying move by investors into the German currency. Adrian Schmidt, an economist at Chase Manhattan Bank, said: "This is a matter of Deutschmark strength. Investors are worried that German interest rates will turn out to have stopped falling."
Otmar Issing, the Bundesbank's chief economist, contributed to these worries yesterday by saying that German rates were at the correct level for the time being and would be governed by money-supply growth. "Big changes in monetary policy are not in the immediate future," he said. Traders fear that figures due this week will show M3 growth in double figures.
Steve Barrow, an analyst at Chemical Bank, said there had recently been unwarranted optimism about the pound. "The political situation will continue to undermine sterling irrespective of how the Deutschmark performs," he said.
A fall in the dollar against both the yen and the mark also contributed to sterling's woes. The US currency dropped by more than 1 to reach a five-week low of 103.80 by the London close, prompting rumours of Bank of Japan intervention to limit its slide. It also lost more than a pfennig, falling to DM1.4419.
The trigger was news of an unexpected shrinkage in Japan's trade surplus last month. The politically sensitive bilateral surplus with the US was only $1.55bn, the lowest for 12 years and less than half its level a year earlier.
Last June's controversial pact on car exports from Japan to the US had a clear impact. Japan's vehicle exports were 11.5 per cent lower than a year ealier, and its imports 38.4 per cent higher.
The overall Japanese surplus dived to $467.08m, from $2.75bn a year earlier. It was the seventh monthly fall in a row.
An official from the Ministry of Finance said the trend was likely to continue even though the yen had weakened against the dollar in recent months. Economists agreed that Japanese imports were likely to pick up further as the economy recovered. But US President Bill Clinton and Japanese Prime Minister Ryutaro Hashimoto are due to meet on Friday and are expected to touch on trade tensions in other areas such as insurance and photographic film.
Wall Street was closed yesterday. New Year holidays in the Far East during the week are expected to make markets more volatile.