Sterling hit fresh 7-1/2 year lows against the dollar and European shares tumbled again on Wednesday as fears intensified about the banking sector, knocking Barclays shares down more than 20 percent.
Investors rushed to buy government bonds, which sent two-year euro zone government bond yields to a record low.
News that global miner BHP Billiton would cut 6,000 jobs and close its giant mine in Australia highlighted concerns that the credit crunch, well into its second year, is savaging the real economy and squeezing global demand for commodities.
On Tuesday, Wall Street ushered in the Barack Obama Presidency with a record Inauguration Day drop as banking concerns overwhelmed expectations the new administration would tackle the crisis and help the economy.
"The party balloon has burst. Sadly the Barack Obama rally which we may have been looking for looks a bit like a damp squib. The banking industry is in a state of serious concern," said Justin Urquhart Stewart, director at Seven Investment Management. MSCI world equity index fell 0.9 percent, losing for the third consecutive day. The FTSEurofirst 300 index of leading European shares dropped 1.8 percent.
Emerging stocks fell 1.4 percent.
Shares in Barclays fell as much as 23 percent to their lowest level since 1985. Other UK banks are also under the hammer despite a second British bank bailout launched by the government on Monday.
STERLING FREEFALL
Sterling fell as low as $1.3737. On top of banking concerns, investors are worried the Bank of England will cut UK interest rates -- already at a record low of 1.5 percent -- even further to boost the economy.
Investors expect the BoE to cut again next month, by half a point, which would further dampen sterling's yield premium. But it could go much further.
Bank of England Governor Mervyn King said late on Tuesday that quantitative easing measures were now under consideration.
Such unconventional measures would take the form of the central bank buying a range of financial assets, thereby boosting the money supply and increasing available credit to companies, he said.
With the latest decline, sterling has lost around 7 percent against the dollar this week.
"The currency pair is neutral to slightly undervalued on most fundamental measures. As such, at current levels the currency pair is now at extreme and favourable levels for corporates who need to hedge medium to long term earnings," Bank of Scotland Treasury said in a note to clients.
The cost of insuring UK sovereign debt against default, shown on five-year Credit Default Swaps, widened to 143 basis points from below 100 two weeks earlier.
March Bund futures rose 44 ticks. Two-year euro zone government bond yield hit a historic low of 1.436 percent.
The premium that investors demand for buying less liquid European government debt over benchmark German bonds remained near historic highs partly due to fears about possible sovereign credit ratings downgrades.
The dollar fell 0.15 percent against a basket of major currencies. U.S. crude oil fell 1.3 percent to $40.33 a barrel.