Italian bond yields rose on Tuesday after a closely-watched debt auction gave little sign the country would be able to issue debt at sustainable levels without the support of the European Central Bank.
Traders said the ECB bought Italian bonds before and after the auction, but in low volumes, which suggested 10-year yields , which were up 9 basis points on the day to 5.67 percent, could rise again towards 6 percent unless the ECB stepped up its game.
How committed are they to keep yields down, that's the problem, said Alan McQuaid, chief economist at Bloxham Stockbrokers. It's sort of against their will and there are concerns about how long they are going to stay in the market.
The rise in Italian yields added to growing fears about the euro zone debt crisis, with a Greek default increasingly being priced in and concerns over the exposure of the French banking sector in particular to peripheral debt.
Reuters calculations based on Markit credit default swap prices put the probability of Greek default at 90 percent. Greek two-year bond yields hit a record of close to 94 percent during the session.
Amid signs Germany may be beginning to consider the possibility of a default, Athens is scrambling to meet conditions to receive further aid.
If Germany are preparing a plan B it looks as though the people running the show are running for the hills and that's not going to improve confidence, said Rabobank rate strategist Richard McGuire.
German Bund futures FGBLc1 marked new highs at 138.91 before the Italian auction then retreated on talk, later denied by the French president's office, that Nicolas Sarkozy and German Chancellor Angela Merkel would make a statement on Greece later in the day.
They last traded 39 ticks down at 137.85, having fallen as low as 137.55 earlier in the session.
We reached quite stretched levels, so headlines like this will see some paring of positions, a trader said.
People who were short risk may be taking some profits.
UBS technical strategist Richard Adcock said the Bunds' retreat from the record highs activated stops on his recent long recommendations at 137.65. This took UBS on the sidelines for the short-term, although he said the longer-term outlook still looked bullish.
Bloxham's McQuaid said the move was most likely to be short-lived and he saw Bund yields heading towards 1.5 percent in the near term from 1.79 percent on Tuesday.
Italy sold 6.5 billion euros of bonds, paying higher costs to sell new five-year paper as demand dwindled .
The auction came as the five-year Italian yield spread over Germany hit a record high and the 10-year spread briefly topped 400 basis points, reversing almost all the tightening seen since the ECB began buying Italy's bonds in August.
The amounts of bids compared with the amount on offer was well below this year's average for 5-year Italian bond sales, despite the paper offering a yield pick-up of around 30 basis points compared with the current five-year benchmark.
Markets were positioned for a weak auction, but no failure and that's what they got, said Credit Agricole rate strategist Peter Chatwell. The point to take from these auctions is that yields appear to be on the rise for Italy, despite the ECB's effort...so far, Chatwell said.
Yields on shorter-dated Italian bonds have risen more than on their longer-dated counterparts this month, narrowing the 2/10-year spread by around 70 basis points.
The Greek, Irish and Portuguese yield curves all inverted as their debt situation deteriorated.
There are tell-tale signs the Italian curve is starting to take on the shape of a credit curve as they get increasingly shut out of markets, Rabobank's McGuire said.