European policymakers tried to turn a more powerful fire hose on the euro zone debt crisis on Thursday but financial markets were unimpressed with their response.
The European Central Bank resumed buying government bonds after a four-month break and announced new longer-term funding for liquidity-starved banks. But after a brief hiccup, Italian and Spanish bond yields continued their inexorable climb toward danger levels.
The executive European Commission urged holidaying euro zone leaders to consider swiftly boosting the size of their financial rescue fund, but was promptly rebuffed by the Germans and Dutch.
ECB President Jean-Claude Trichet said the central bank's controversial program of buying government paper in an effort to stabilize markets, inactive since March, was ongoing.
You will see what we do, he told a news conference.
Traders saw the ECB enter the market as Trichet spoke but an EU monetary source said purchases were limited to Irish and Portuguese bonds and there were no plans to buy bonds of other nations.
Spanish and Italian 10-year bond yields, which had fallen in anticipation of ECB action, rose again in volatile trading and safe haven German Bund futures jumped.
The 10-year Italian/German bond yield spread widened to 392 basis points, the biggest since the launch of the euro in 1999. The equivalent Spanish spread expanded to 400 bps from 386 bps at Wednesday's settlement.
The office of French President Nicolas Sarkozy said he would discuss the situation with German Chancellor Angela Merkel and Spanish Prime Minister Jose Luis Rodriguez Zapatero by telephone on Friday after having talked to Trichet on Thursday.
EU Economic and Monetary Affairs Commissioner Olli Rehn broke off his vacation and returned to Brussels, where he was due to hold a news conference on developments in the euro zone on Friday.
Traders said they were not convinced bond-buying would be effective in stopping contagion to the euro area's third and fourth largest economies.
The ECB may have missed an opportunity to act more convincingly. The key now is to see whether and in which size the ECB actually intervenes in the Spanish and Italian bond markets, economist Holger Schmieding of Berenberg Bank said.
Trichet acknowledged the decision was not unanimous, but an overwhelming majority supported it. That revived memories of a damaging split on the governing council last year, when then German Bundesbank chief Axel Weber publicly opposed the policy.
It also raised questions about whether the ECB is waiting for Rome and Madrid to take extra fiscal adjustment measures before it will buy their bonds, or whether the central bank was unable to agree on widening the scope of bond-buying to them.
Trichet said the central bank would conduct a special six-month liquidity operation and keep providing unlimited short-term funds to banks at least until next January.
Several banks in Greece, Portugal and Ireland remain totally shut out of market funding and some Spanish and Italian lenders are also dependent on ECB funds.
European Commission President Jose Manuel Barroso said in a letter to EU leaders: I... urge a rapid re-assessment of all elements related to the EFSF, and concomitantly the ESM, in order to ensure that they are equipped with the means for dealing with contagious risk.
In a quick put-down, a finance ministry spokesman in EU paymaster Germany said it was unclear how re-opening the debate about financial backstops so soon after last month's emergency summit could help calm markets.
The European Financial Stability Facility, which has bailed out Ireland and Portugal and will run a planned second package for Greece, has a maximum capacity of 440 billion euros. It will be replaced in 2013 by a 500-billion-euro permanent European Stability Mechanism.
The 17 euro zone leaders left the size unchanged when they agreed on July 21 to widen the funds' role to buying bonds in the secondary market and providing precautionary credit lines to states under pressure on credit markets.
Market analysts and economists say the EFSF would need to be at least doubled and perhaps trebled to pre-empt attacks on larger economies such as Italy and Spain.
Madrid sold 3.3 billion euros ($3.14 billion) in short-term bonds earlier on Thursday but had to pay a sharply higher borrowing cost.
Across the globe, Japanese authorities acted to weaken a strong yen, joining Switzerland in efforts to tame currencies buoyed by safe-haven demand from investors fretting about the health of the global economy and the euro zone's debt woes.
Trichet said those moves were not part of any concerted multilateral policy approach.
Italian Economy Minister Giulio Tremonti voiced frustration at the pace of the ECB response to a selloff of Italian stocks and bonds over the last three weeks.
I note that the Bank of Japan today launched quantitative easing and the Swiss central bank cut rates to zero. We are waiting for (ECB) decisions if possible, but desirable, he said.
Tremonti said when he talked to Asian investors, they said: If your central bank doesn't buy your bonds, why should we buy them?
Asked whether Italy was taking adequate steps to strengthen its public finances, Trichet said pointedly it was necessary to frontload structural measures. A 48-billion-euro austerity program passed by parliament last month delays the brunt of spending cuts until after a 2013 general election.
There is strong opposition to the ECBb bond-buying policy among guardians of central banking orthodoxy in Germany who argue it compromises the core mission of fighting inflation. German Bundesbank president Jens Weidmann broke off his holiday to attend Thursday's ECB policy-setting meeting.
The ECB bought 76 billion euros of sovereign bonds, believed to be only Greek, Irish and Portuguese, to stabilize markets last year but critics said the Securities Market Programme had only limited, short-term impact and did not prevent any of those countries requiring EU/IMF bailouts.
JITTERS ABOUT FRANCE
Japan sold one trillion yen ($12.6 billion) and its central bank eased monetary policy on Thursday to try to push down the yen against the dollar and euro.
Economy Minister Kaoru Yosano said policymakers of major economies needed to discuss currencies at either Group of Seven or Group of 20 level -- the first official call for multilateral action since twin crises over U.S. and euro zone debt became acute last month.
Official sources in several G7 countries said on Wednesday they were not aware of any move so far to involve the G7 or G20, but that France, which holds the chair of both groups this year, might consult those forums if the turmoil persists.
In addition to Italy and Spain, some investors are becoming jittery about the finances of France, the euro zone's second biggest economy. The spread of 10-year French government bonds above German Bunds hit a euro lifetime high of 0.81 percentage point on Wednesday.
Any major expansion of the euro zone bailout fund would put a greater financial burden on Paris, the second largest contributor to the fund, and could push up its yields further.
In another pointer to spreading concern, Britain's Financial Services Authority has asked UK banks to detail their exposure to Belgian sovereign debt, adding it to a list of countries with debt problems including Portugal, Ireland, Italy, Greece and Spain, the finance director of Lloyds bank said.
(Additional reporting by Sophie Louet in Paris, Marius Zaharia in London, Stanley White and Leika Kihara in Tokyo, Claire Sibonney in Toronto; Writing by Paul Taylor, editing by Mike Peacock/Janet McBride and Sonya Hepinstall)