``We are all feeling distinctly queasy,'' said one senior equity salesman in London. ``There's almost a sense of emotional damage in the market and the mood has gone from skittish to downright grim.'' The interest rate fears were sparked by comments from two voting members of the Fed's rate-setting committee.

Federal Reserve Bank of Atlanta President Jack Guynn said he did not see many signs that the Fed's three interest rate rises in 1999 were slowing consumer demand. His colleague from San Francisco, Robert Parry, said the Fed had so far taken a `cautious approach' in reacting to inflation.

Wall Street dived on the comments, with the Dow Jones industrial average ending 2.16 per cent lower and the technology-heavy Nasdaq recording its fourth largest drop in history of 3.29 per cent.

Following the comments of his colleagues, testimony by Federal Reserve Chairman Alan Greenspan to the US Senate Budget Committee at 1500 GMT will be closely watched, analysts said.

The major European markets all plunged well over one per cent in early trading, but then recovered some ground. By 1000 GMT, the Eurotop 300 index was down 0.93 per cent, and the Euro STOXX 50 index of euro zone blue chips showed a 0.96 per cent loss. London's FTSE index was off 0.86 per cent, Frankfurt's DAX0.73 per cent and the CAC in Paris 0.91 per cent.

Investors have been rattled this year by the prospect of a succession of interest rates increases on both sides of the Atlantic which would radically alter the attraction of holding shares instead of switching into interest-yielding instruments. In Britain, where rates were raised earlier this month and more increases are forecast, the stock market currently languishes at its lowest point for two and a half months. Investors were watching closely for Tuesday's inflation data for December that could give clues as to the direction of monetary policy. The Nasdaq rout - the third-largest fall ever in points terms -- rubbed off on hi-tech stocks, which led the downward slump.

Prototype British Internet stock Freeserve fell by 5.2 per cent to 462.5 pence while online directory scoot.com slumped 5.3 percent to 168 pence. Interest rate worries traditionally hit Financial stocks the hardest and British banks were clearly lower. Barclays shed 1.2 percent to 1,418, while HSBC lost two percent to 702.5 pence. Music group EMI bucked the downward trend, gaining 2.8 percent to 740 pence on the strength of positive press feedback to its merger with Time Warner's music division.

Telecoms lead London retreat
In London, telecoms led the retreat, with Vodafone down 2.4 per cent, and British Telecommunications down 1.5 per cent. Norwich Union bucked the trend, rising 1.27 per cent after the insurer reported a 50 per cent rise in new life and pensions business in 1999. In Frankfurt, Siemens provided a rare bright spot with its first quarter results released late on Monday showing earnings almost doubling before extraordinary items, rising 5.9 per cent.

In Paris and Milan, technology and telecom issues led the sell-off. Equant was off 3.84 per cent. Telecom Italia Mobile lost 2.45 per cent. Pinault-Printemps-Redoute lost five per cent despite reporting a 14.5 per cent hike in 1999 sales.

The euro, which had a close brush with parity against the dollar on Monday, came off highs close to $1.0090 to stand around $1.0045 in mid morning European trading. Dealers cited European corporate selling.

``Market action has confirmed that parity is still a substantial barrier,'' said Teis Knutsen, chief strategist at SEB Merchant Banking in Copenhagen. ``The euro is still unable to trade on its own merit, but in an environment of weaker US stocks the euro would tend to do better.'' The dollar was holding gains made on Monday against the yen following the weekend meeting of G-7 finance ministers, trading around 106 yen.

Government bond prices firm
The rate fears spurred demand for safe-haven government bonds following a strong performance by US. Treasuries in Newe York. At 1015 GMT, the euro benchmark German 10-year bond yielding 5.524 per cent, down 0.040 points. Oil was giving up some of its recent gains on profit-taking and on forecasts of an end to below-normal winter temperatures in the United States.

Prompt Brent crude futures dipped 21 cents a barrel to $25.85 the market opened, continuing a correction sent in late Monday trade. Gold was holding steady at just below $290 an ounce ahead of the latest Bank of England sale of the metal, the results of which were due to be announced at 1215 GMT.