Yields on Italian and Spanish bonds climbed back to unsustainable levels on Tuesday, putting the focus squarely on France with risks mounting by the day that euro zone debt contagion would ensnare one of the region's biggest economies.
Top-rated European nations came under increasing pressure from investors betting that the euro zone could eventually break up with the yield spread of French, Austrian and Belgian 10-year bonds over German Bunds rising to euro-era highs. The equivalent Dutch spread hit levels not seen since early 2009.
Spain issued short-term debt at yields seen 14 years ago, highlighting how most European governments are struggling to raise funds.
The cost of insuring against a default by France rose to record highs, a grim reminder that one of the biggest economies in the region would come under the scanner of bond market vigilantes.
The ongoing turmoil in euro zone debt markets led to widespread risk aversion with European stocks falling, U.S. stock futures pointing to a weak start on Wall Street and the euro easing against the dollar and the safe-haven yen.
The fact that Holland and Austria (spreads) are moving out -- countries which were seen as cohorts of Germany in the past -- is a worrying development, said Nick Stamenkovic, rate strategist at RIA Capital Markets.
Investors are looking to Germany given the worries not just about Italy and Spain but about the future of Europe as a whole.
Any relief from the ongoing formation of technocrat-led governments in Italy and Greece proved short-lived. Italian Prime Minister-designate Mario Monti meets the leaders of the country's biggest two parties on Tuesday to speed up efforts to deliver painful reforms.
And while a Monti-led government has improved the likelihood of a more credible fiscal policy, the market still needs to be convinced.
Italy's 10-year bond yields rose more than 30 basis points above 7 percent, perceived to be a dangerously high level to service debt. It also pushed Spanish 10-year yields well above 6 percent for the first time since the European Central Bank started to buy the country's bonds in August.
The spread, or interest rate gap, of Italian bonds over German government bonds, or Bunds, remained elevated at over 500 basis points.
Particularly worrying has been the steep rise in French bond yields -- over 40 basis points in 10-year yields in the past two weeks.
French banks are among the biggest holders of Italy's 1.8 trillion euro public debt pile and a study of euro zone countries on Tuesday warned France's inability to make rapid adjustments to its economy was a serious concern and should be ringing alarm bells for the euro zone.
All of this dragged European shares lower for the second straight day. The FTSEurofirst 300 .FTEU3 index of top European shares was down 1.3 percent at 963.17 points after losing 0.9 percent on Monday.
U.S. stock index futures pointed to a weaker open for equities on Wall Street with futures for the S&P 500, the Dow Jones and the Nasdaq 100 down 1 to 1.3 percent.
A bleak economic outlook for the region also weighed. German analyst and investor sentiment slumped in November, a survey from the influential ZEW economic think tank showed.
That overshadowed data which showed Germany and France posted solid growth in the third quarter although euro zone countries at the sharp end of the crisis were faring much worse.
The recent downturn in financial markets has raised the urgent need for recapitalisation at banks, prompting them to sell assets, especially those of the euro zone, to make up for losses elsewhere.
The euro eased against the dollar and the yen, stuck near the bottom of its recent trading range. The euro fell 0.7 percent to $1.3529, trading near the lower end of its trading band since late October of $1.3484 to $1.4248.
The euro zone debt crisis continues to escalate ... The ultimate outcome is still unclear - whether the euro zone moves closer to fiscal integration or whether there is a more disorderly break-up, said Lee Hardman, currency economist at BTMU.
Japanese and U.S. government bonds drew safe-haven bids on Tuesday, with $31 billion of 0.3 percent five-year JGBs fetching healthy demand and Treasuries extending their rally.
December German Bund futures were 64 ticks higher at 138.88 with benchmark 10-year yields down two basis points at 1.76 percent.