Losses accelerated in mid-afternoon trade but were pared somewhat in the final half hour.
"We've had a rough couple of days, with bond yields approaching 5%," said Jay Suskind, director of trading at Ryan, Beck & Co. "This market has been strong, so it's an excuse to take money off the table, but this move is clearly interest-rate driven."
The Dow industrials closed down almost 130 points at 13,465, after earlier trading as low as 13,437.
Of the Dow's 30 components, 25 retreated, including Dupont , Home Depot Inc. , IBM , Intel Corp. , and United Technologies .
Concerns about European stocks also weighed on the U.S. market, after Morgan Stanley issued "a full house sell signal" on the region, predicting a 14% correction over the next six months.
In addition, reports that Turkish troops have entered Northern Iraq while chasing Kurdish guerrillas, added to overall jitterness while pushing oil prices briefly above $66 a barrel, traders said.
The S&P 500 index fell 13.57 points to 1,517.38, while the Nasdaq Composite lost 24.05 points to 2,587.18.
Bucking the lower trend, TD Ameritrade gained 3.6% after two hedge funds with a stake in the brokerage suggested it find a merger partner. Charles Schwab & Co. said it's not interested in a merger.
Trading volumes showed 1.548 billion shares exchanging hands on the New York Stock Exchange and 2.122 billion trading on the Nasdaq stock market. Declining issues outpaced gainers by 13 to 3 on the NYSE and by 20 to 9 on the Nasdaq.
By sector, pharmaceuticals , Internet , telecoms , and oil shares all fell sharply, while few sectors advanced.
Homebuilding stocks were also under pressure after the National Association of Realtors lowered its forecasts for key housing indicators for this year and next. Among homebuilders, shares of Toll Brothers Inc. , KB Home and Hovnanian all fell sharply.
Rising rates, yields
Stocks futures extended losses before the open following a Labor Department report showing unit labor costs - a key gauge of inflationary pressures - were revised higher to 1.8% annualized from 0.6% previously in the first quarter.
Economists surveyed by MarketWatch expected costs to be revised to 1.7%.
"This upward unit labor cost tilt is certainly a troublesome development at the Fed," said Mike Englund, chief economist at Action Economics.
The market was already under pressure before the data, with investors continuing to re-assess the valuations of share prices in light of rising bond yields, which offer a low-risk alternative to stocks.
"If we continue to get really strong economic numbers and bearish inflationary numbers along with a hawkish Fed, and if we see a big correction overseas, then we could see a correction here," said Ryan, Beck & Co's Suskind.
With rising yields attracting buyers, bond prices actually rose, sending yields lower, after the data. The benchmark 10-year Treasury bond gained 6/32 to close at 96 12/32, while its yield stood at 4.98%.
On Tuesday, the Dow industrials fell 80 points, after data showing improving sentiment in the service sector and remarks from Federal Reserve Chairman Ben Bernanke who continued to highlight the Fed's concerns over inflation.
U.S. government bonds are also under pressure from rising yields globally. The European Central Bank, as expected, hiked its key rate to 4% from 3.75%.
Sell, sell, sell Europe?
Adding pressure to European stocks and the U.S. market, Morgan Stanley issued a "full house sell signal," citing three of its leading indicators: fundamentals, which include bond yields, as well avaluation and risk.
"Such a full house sell signal across these three indicators is rare, and has occurred only five times since 1980," said Morgan Stanley analyst Teun Draaisma in a report.
The dollar still edged higher against the euro, as investors had widely anticipated the ECB's decision. The U.S. currency, meanwhile, was down against the yen.
Oil futures rose, with crude for July delivery gaining 35 cents to $65.96 after weekly reports on energy inventories and reports that Turkish troops had entered Northern Iraq.
Gold, however, continued to fall amid dollar weakness and as traders gauged the metal's investment prospects. Gold for for August delivery fell 50 cents to $674.60 an ounce on the New York Mercantile Exchange.
Whole Foods Market fell 3% after the Federal Trade Commission decided to file a lawsuit to block its merger with Wild Oats . Morgan Stanley cut Whole Foods rating to equal-weight from overweight on the decision.
Separately, Goldman Sachs downgraded Borders to sell from neutral, saying the FTC decision makes a merger with Barnes & Nobles less likely.
Guess gained 3.8% after the Los Angeles retailer lifted its annual earnings outlook.
GlaxoSmithKline fell 0.8% as a hearing in Congress debates the Food and Drug Administration's role in approving its diabetes drug Avandia.
Glaxo put out its own study on Tuesday defending the drug's cardiovascular safety, after a separate study suggested the drug increases heart attack risk.
By Nick Godt