World stocks and the dollar tumbled on Wednesday while the yen and government bonds soared as concerns for the health of the U.S. economy stirred the biggest wave of risk aversion since August in global financial markets.

U.S. 10-year Treasury yields fell below 4 percent for the first time since 2005 and European credit spreads widened after the Federal Reserve projected on Tuesday that the world's biggest economy would slow next year to between 1.8 and 2.5 percent, sharply lower than earlier forecasts in June.

The credit crunch since August, stemming from defaults on U.S. mortgages, has hit banks globally and pushed up interbank borrowing costs, posing risks to economic growth.

Concerns spook investors about further possible write-downs by banks, while inflation concerns were on the rise with oil prices blasting past $99 to a record.

All of these factors sparked a sell-off in risky assets and drove funds into safe-haven assets. European stocks fell to levels seen when the credit crunch first took hold, while some interbank lending rates breached August levels.

You've still got this cocktail of the very weak dollar, high oil price, uncertainty over the credit crunch (and) less than soothing noises from the Fed, said Richard Hunter, head of equities at Hargreaves Lansdown Stockbrokers.

Clearly there is a wall of cash out there but there are not too many people prepared to commit large sums of capital to the market given this uncertainty.

The FTSEurofirst 300 index was down 1.7 percent on the day to hit a three-month low. U.S. stock futures were down 1 percent, indicating a weaker open on Wall Street later.

The MSCI main world equity index was down 1 percent, with its year-to-date gains halving to around 7 percent compared with earlier in November when the index hit a record.

We have reached unbearable levels for oil and currencies... We have to accept negative surprises for earnings for this quarter and next year, said Romain Boscher, fund manager at Groupama Asset Management.

The dollar hit record lows around $1.4850 per euro while the yen hit a 2-1/2 year high of 108.27 per dollar.

European financial credit spread, as measured by iTraxx, hit record highs, driven by spiraling fears over bank write-downs and illiquidity.

The wider iTraxx Crossover index widened 17 bps to 402 bps. It was a blow-out in this index in August which marked the start of a sell-off.

NEW YEAR FUNDING CONCERNS

Funding concerns over the Christmas and New Year period, on top of general credit concerns, are pushing up money market rates once again to or above levels seen in August.

London interbank offered rates for two-month euro deposits hit 6-1/2 year highs of 4.65250 percent, with the premium over expected policy rates for the same period reaching 57 basis points.

The liquidity crisis has set in train a process of bank balance sheet contraction that will likely crimp both consumer expenditure and business investment across the developed world well into 2008, Bank of Scotland Treasury said in a note.

The bank said the shrinkage in the asset-backed commercial paper market and the effective closure of significant parts of the capital markets is forcing banks to have greater recourse to interbank-rate based funding.

At the same time the supply of period funding into this market is being restricted as investment funds build liquidity buffers ahead of potentially large redemptions, it said.

Emerging sovereign spreads widened 7 bps while emerging stocks were down more than 2.6 percent.

The December Bund future rose 45 basis points, tracking gains in U.S. Treasuries.

U.S. light crude was up 0.3 percent at $98.30 after rising above $99 earlier. Gold rose to $799.10 an ounce.

(Additional reporting by Michael Taylor; editing by David Christian-Edwards)