The dollar surged and stocks fell Tuesday after China's first interest rate hike in three years reignited concerns that the authorities there might dampen growth as they try to restrain an overheating economy.
The rate increase also left investors pondering whether the U.S. and China were looking to ease market tensions ahead of a crucial meeting of finance ministers this weekend.
Whatever the truth behind such speculation, the decision clearly weighed on sentiment and demand for more risky assets — in times of heightened risk aversion, the dollar gains ground through its status as a safe haven currency while stocks retreat.
In Europe, Germany's DAX closed down 25.94 points, or 0.4 percent, at 6,490.69 while the CAC-40 in France fell 27.33 points, or 0.7 percent, to 3,807.17. Britain's FTSE 100 index of leading British shares ended 38.63 points, or 0.7 percent, lower at 5,703.89.
In the U.S., the Dow Jones industrial average was down 113.53 points, or 1 percent, at 11,030.16 around midday New York time while the broader Standard & Poor's 500 index fell 10.77 points, or 0.9 percent, to 1,173.94.
Meanwhile in the currency markets, the euro was 1.2 percent lower on the day at $1.3784 while the dollar rose 0.6 percent to 81.75 yen.
Trading had been lackluster up to the point when the People's Bank of China announced that it was raising its key one-year interest rate by a quarter of a percentage point, with effect from Wednesday.
The main market response was to send the dollar higher, amid market chatter that the move could be part of a series of confidence-building measures between the U.S. and China — one theory doing the rounds is that the Chinese monetary authorities would allow their currency, the yuan, to appreciate more markedly against the dollar in return for the Federal Reserve limiting the amount of money injects into the U.S. economy.
The rate hike comes barely a day after U.S. Treasury Secretary Timothy Geithner insisted that the Obama administration was not looking for the dollar to fall in an attempt to shore up economic growth.
No country "can devalue its way to prosperity," said Geithner.
His comments come ahead of this weekend's meeting of finance ministers and central bankers from the Group of 20 industrialized and developing countries in Korea — the yuan's artificially low level against the dollar is likely to be one of the main issues at the meetings amid growing talk of a currency war.
"The presumption is that ahead of the G-20, this is all very coincidental," said Neil Mellor, senior currency strategist at Bank of New York Mellon. "It's natural for the market to infer this but it's difficult to stack up."
Most importantly, Mellor said the Fed has a mandate to be independent of politicians.
Comments from Fed officials, including Atlanta Fed President Dennis Lockhart and Chicago Fed President Charles Evans indicated that there's still a big chance that the central bank will be announcing fresh measures after its next policy meeting on November 3. The assumption in the markets is that the central bank will sanction further asset purchases — so-called quantitative easing, or QE — in the hope that growth can be revived and prices prevented from falling.
"A U.S.-China 'deal', if such a thing exists at all or appears to implicitly materialize, will be about getting Congress off China's back, while China acts on the basis of domestic factors," said Marc Ostwald, markets strategist at Monument Securities.
The Chinese rate hike deflected market attention from a raft of U.S. earnings statements, though the market mood has hardly been helped by fairly downbeat outlook statements from the likes of Apple and IBM.
However, Goldman Sachs bucked the trend, rising nearly 3 percent after it reported forecast-busting earnings.
Earlier, Japan's benchmark Nikkei 225 stock index gained 0.4 percent to 9,539.45 as the yen dropped modestly against the dollar to the relief of the country's exporting base.
South Korea's Kospi slipped 1.0 percent to 1,857.32 while Australia's S&P/ASX 200 rose 0.1 percent at 4,655.70. Elsewhere, Hong Kong's Hang Seng index rose 1.1 percent to 23,726.07.
The Shanghai Composite Index jumped 1.6 percent to 3,001.85 on investor optimism that the government will boost spending in sectors such as biotech and alternative energy as part of the country's economic strategy for the next five years.
Benchmark oil for November delivery was down $1.94 to $81.14 a barrel in electronic trading on the New York Mercantile Exchange.
Associated Press Writer Alex Kennedy in Singapore contributed to this report.