The FTSE 100 index fell more than 99 points to end at 5,957.3, below the symbolic 6,000 mark. The Dow Jones index closed 225.43 points, 2.1 per cent, lower at 10,598.47.
The Bank of Japan resisted pressure to ease monetary policy in an assertive display of independence at its council meeting yesterday. Masaru Hayami, the BoJ governor, went further, saying co-ordinated intervention to hold down the yen on the foreign exchanges would be "rather difficult".
His remarks dashed expectations that this weekend's G7 meeting could reach a constructive agreement about how to stabilise the currency, although the subject will be at the top of the agenda.
Kiichi Miyazawa, Japan's finance minister, said discussions with the US Treasury about joint intervention would take place "from here on".
The rising yen threatens prospects for economic recovery in Japan. Paul Krugman, the MIT economist who has been an outspoken advocate of looser monetary policy, said: "Hopes of recovery are starting to look like a self-denying prophecy: as soon as investors start to think the worst is over, the yen pops up and undermines the expansion."
The yen was further strengthened, and the dollar undermined, by new figures showing the US trade deficit reached a record $25.18bn in July, far worse than expected.
Imports soared to $104.22bn, also a record. The bilateral US deficits with Europe, Japan and China reached new highs, and are sure to fan the flames of protectionist sentiment in America.
The figures were in the red by far more than expected. Stan Shipley, an economist at Merrill Lynch, said: "These numbers don't look good." The dollar had fallen more than 2 to just over 104 at one stage.
The euro strengthened above $1.0450 in the fallout. Yesterday brought news that the Ifo business survey climbed for the fourth month running in August, confirming growth is picking up in Germany.
Some analysts predicted the dollar would not drop below the 100 barrier. Stephen Lewis at Monument Derivatives said investors in Japanese assets would now take profits, halting the yen's upswing.
Others, however, feared a plunge in the dollar. Professor Krugman compared it to Wile E Coyote, the cartoon character who keeps on running past the edge of the cliff until he looks down.Reuse content