The bad news was compounded after hours as Moody’s downgraded Italy by three notches, from Aa2 to A2.
The prospect of a Greek default was heightened by an apparent delay in the struggling peripheral state’s next package of aid.
Eurozone authorities are reviewing the level of losses that private banks should take on Greek debt, yet finance minister Evangelos Venizelos last night insisted that its finances could survive until “mid-November”.
Nonetheless, the FTSE slumped 2.6 per cent to its lowest close since July 2010. In France the CAC closed down 2.6 per cent; the German DAX shed nearly three per cent; the Euro Stoxx 50 ended 2.2 per cent down.
Banks took some of the heaviest hits, with Franco-Belgian financial group Dexia coming into sharp focus on worries about its high exposure to Greece. Its shares fell 22.5 per cent.
Barclays shed 7.6 per cent yesterday, while Lloyds Banking Group and Royal Bank of Scotland also took knocks.
The Eurozone crisis is now so serious it will plunge the region into recession by the end of the year, analysts at both Goldman Sachs and credit rating agency Standard & Poor’s warned.
Goldman is now predicting “a recession in the short term and stagnation next year” for Europe, and warned that the US economy will also suffer from the crisis.
S&P’s analysts said they “still do not expect a genuine double dip to occur in the Eurozone”, but added that western Europe is vulnerable to a slide back to economic contraction.
Goldman and S&P said they see the US as having a 40 per cent chance of slipping back into recession, despite the Federal Reserve’s efforts to restart the economy. Goldman expects US GDP growth of 1.4 per cent next year.
Credit default swaps (CDS) were hit for both banks and sovereigns yesterday, as fears escalated. German five-year CDS rose to 121 basis points while Belgium’s five-year CDS gained 14 bps to 286 bps, nearly a record high.
US stocks flirted with a bear market in early trading, yet a late rally saw the Dow Jones spike by 3.5 per cent, as bargain-hunters snapped up cheap shares amid the turbulence. The VIX volatility measure hit a two-month intraday high of 46.88 yesterday.
Earlier in the day Federal Reserve chief Ben Bernanke said it was “prepared to take further action as appropriate to promote stronger economic recovery”.