LONDON: Italian bond yields rose above 6 percent on Tuesday for the first time in 2-1/2 months, following Spain higher as investors rattled by Greece's failure to form a new government cut exposure to riskier assets.
German Bund futures reversed losses to end slightly up on the day and could scale new highs in the coming day after Greece's President said the country would hold new elections, adding to fears of a possible exit from the euro.
Pressure on Spanish and Italian bonds had eased with German yields edging up earlier after the euro zone narrowly avoided recession in the first quarter of 2012 but the reprieve was short-lived after the Greek announcement.
Italian 10-year yields rose 16 basis points to 6.03 percent, the highest since Feb. 2, while Spanish yields jumped 12 bps to 6.37 percent with the Irish equivalent surging 32 bps to 7.36 percent.
A sustained rise above 6 percent could see their borrowing costs accelerate to prohibitively high levels which pushed Ireland and Portugal to seek international aid.
Markets have already begun to price in the risk of a break-up of the euro zone with fears that chaos in Greece will drag down larger countries such as Spain and Italy.
"The risks for the euro area are maybe as high as they are for Greece...Europe will have to decide what to do. Will they let Greece to default or step towards more fiscal union. This supreme moment is coming closer," said Piet Lammens, a strategist at KBC.
ECB WATCH
Given the sharp rise in Italian and Spanish bond yields, market participants are closely watching for any signs of the European Central Bank resuming its bond buying programme should the paper come under further pressure.
Italy will test market appetite for its cheapened paper on Thursday at a 2.5 billion euro sale of shorter-dated bonds, relying heavily on demand from domestic banks with international investors reducing their holdings steadily this year.
Earlier, a government official said Greece will repay a 430 million euro maturing bond - which was not included in its recent debt restructuring but this offered markets little comfort.
"The most important thing is whether they end up defaulting on 150 billion euros rather than 430 million," said Gary Jenkins, director at Swordfish Research.
"If they were to disorderly default then the ECB, EU and the IMF lose a huge amount of money which makes it very difficult for the IMF to come in and increase their backup bailout facilities for the likes of Spain and for politicians to persuade their voters there should be more of a fiscal union."
June Bund futures rose five ticks to settle at 143.45, having fallen as low as 142.96 earlier after data showed the euro zone narrowly avoided recession.
Although the region just avoided recession - gross domestic product stagnated in the first quarter - its debt crisis weighed on the French and Italian economies and German analyst and investor sentiment, reflected in the ZEW survey, fell sharply in May.
German 10-year yields were 0.6 basis points lower at 1.46 percent, just above all time lows of 1.434 percent while two-year yields were also near record lows at 0.7 basis points.
Investors in German bonds may soon get back less than they paid for the debt as they forego any profit and instead seek shelter from the euro zone's storm, driving borrowing costs for the region's safest issuer to unprecedented lows.
"There's been a bit of buying of quality non-euro zone paper such as gilts and Swedish bonds but some accounts have to stay invested in the euro zone and that's why Bunds are perpetually bid," a trader said.
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