Hangover hurts markets

Share prices plunged on both sides of the Atlantic yesterday as investors woke up to the realisation that interest rates are poised to rise around the world.

The Eurotop 300 index of Europe's leading companies fell 4% while the FTSE 100 index fell 3.8%, the 8th largest percentage fall in its 16-year history.

In the US, markets opened sharply lower for the second day and by the London close the Dow Jones industrial average was down more than 200 points, triggering emergency trading curbs to prevent volatility. It continued to fall and was more than 300 points down an hour before the Wall Street close. The US technology index Nasdaq was off 3.8% at the London close after setting a record high on Monday.

Europe could be the first to endure the pain of higher borrowing costs after the European Central Bank meets today. Britain's monetary policy committee meets next week.

In the US, where financial markets often set the tone for Europe, investors could be jittery until the next meeting of the banking authorities in February.

"The US financial markets are waking up to the fact that US interest rates need to go up," said Gerard Lyons, global head of treasury research at Standard Chartered.

The realisation appeared to be reflected in the sharp rise in very long-term US interest rates on Monday when yields on 30-year US government bonds reached two-year highs. That suggested investors expect inflationary pressures to build up in the years ahead, prompting increases in official rates from the the authorities to curb price rises.

Among the sectors hardest hit were the "dot.com" stocks and particularly telecoms as well as companies sensitive to interest rate movements such as banks.

One analyst said highly geared hi-tech stocks were extremely sensitive to interest rates on long-dated bonds because their stock market valuations are based on expectations of future earnings, which might be eroded by higher inflation.

The end of year rally in "dot.com" stocks, fuelled by small investors, also allowed some big players to realise their potential gains yesterday. "It's profit-taking on the back of the recent strong run, and concerns over interest rates have been the catalyst," said Jeremy Batstone, head of research at NatWest stockbrokers.

Mr Batstone said rumours that the European Central Bank was poised to withdraw liquidity injected into the market at the end of the year to cushion any pain from the millennium bug - which failed to materialise - had also served to unbalance sentiment.

Not all shares fell sharply. One of the day's biggest gainers was Marks & Spencer which jumped more than 5% on speculation that it will be taken over by a rival. Some big internet stocks such as Psion also registered rises.

Few analysts suggested yesterday's sharp falls marked the beginning of a prolonged bear market, describing the move instead as a much needed pause for breath in an overheated market.

Many, though, believe the internet sector, which drove much of last year's rally, might be the first to fall back. Byron Wein, the bearish but widely followed chief market strategist at Morgan Stanley Dean Witter, predicted a correction among internet stocks this year. "I am not saying that the internet is not going to reward investors over the long term," he said. "But a number of these stocks have gone ahead of themselves."