The FT-SE index of 100 leading company shares fell by 74.4 points to a ten-week low of 3267.5. It last fell that sharply in October 1992 after Britain's exit from the European exchange rate mechanism.
The slide was echoed around the world, with big falls in share prices in Paris, Frankfurt and New York, where the Dow Jones index closed 51.78 points down at 3839.90.
Finance ministers and central bankers of the Group of Seven leading industrial countries will discuss the turmoil when they meet in Kronberg, near Frankfurt,
European ministers will be particularly attentive to the observations of Alan Greenspan, chairman of the US Federal Reserve Board, on how quickly he expects American short-term rates to rise.
The main cause of yesterday's fall was a crash in the price of government bonds, the IOUs governments sell to bridge the gap between spending and tax income. Their fixed interest payments can be eroded by higher inflation and they become less attractive when bank interest rates rise.
British government bonds (or 'gilts') dropped sharply. Aggressive American 'hedge funds' - which can rapidly transfer billions of pounds between shares, bonds and currencies around the world in pursuit of quick profits - were said to be big sellers. The gilt paying 8 per cent interest and due to be repaid by the Government in 2013 fell by pounds 3 on the day to pounds 107.
Dealers believe that speculative investors such as George Soros, who made an estimated dollars 1bn when Britain left the ERM, are now taking a bath themselves. Mr Soros's Quantum Fund was reported to have lost about dollars 600m last week when the yen jumped against the dollar.
The markets have been particularly feverish since the Federal Reserve three weeks ago raised US interest rates for the first time in five years. That was an attempt to prevent a rise in inflation as economic recovery pushes prices higher. Fears that US rates may rise again soon were exacerbated by figures showing an unexpectedly sharp 3.7 per cent rise last month in orders for US durable goods, such as cars and electronic goods.
The markets fear the rest of the world may have to follow the American lead - if not raising interest rates then cutting them less dramatically. That caution was reinforced by an unexpectedly small cut in French interest rates yesterday. Economists at Nomura, the Japanese bank, predicted that base rates in Britain could soon be climbing back to 6 or 7 per cent from their current 5.25 per cent.
Nomura's influential stock market specialist, Nick Knight, said the FT-SE would fall to 3000 'probably sooner rather than later'.
Fears that inflationary pressure could push British base rates higher are likely to be fuelled today by a survey from the Confederation of British Industry showing that manufacturers' order books are fuller than at any time for four years.
However, the CBI also cut slightly its forecasts of economic growth this year and next, reflecting the unexpected toughness of Budget tax increases. National output is expected to grow by 2.3 per cent this year and 2.4 per cent next year, while inflation stays within the Government's target range.
Stock market report, page 32
Hamish McRae, page 33Reuse content