Italy's funding costs reached a new euro era record at auction on Wednesday, piling pressure on the new Rome government after last week's EU summit failed to convince markets the bloc's debt crisis can be resolved.
Italy paid 6.47 percent to sell five-paper just minutes after Berlin placed 4 billion euros (3 billion pounds) of two-year bonds at an average yield of just 0.29 percent - a sign of how strongly cautious investors favour safety over returns.
Measures agreed by European leaders at the summit to strengthen fiscal discipline have not reassured investors who now fear a raft of credit downgrades from ratings agency Standard and Poor's on some or all of the 15 euro zone countries it has on watch.
Uncertainties on the future of the debt crisis remain high and the market seems to be mainly driven by flight-to-quality this morning, said Annalisa Piazza, a market economist at Newedge Strategy.
Saddled with a debt equivalent to 120 percent of gross domestic product, Italy has seen its funding costs spiral since taking centre stage in the euro zone crisis in early July, raising questions about whether it can afford such rates over the longer term.
Concerns about the widening impact of the crisis on all euro zone members have dented demand for top-quality German paper at some previous auctions.
But at German and Swedish debt sales on Wednesday, investors were prepared to accept ultra-low interest rates to park their money in comparatively safe assets. Germany's 0.29 percent yield was down from 0.39 percent at a similar auction in November, while Sweden - outside the euro zone - sold 5-year bonds at a record low yield of 1.023 percent, down from 3.132 percent in April.
Italy managed to sell 3 billion euros of its five-year benchmark, at the top of an unusually small range it targeted at the auction.
The yield rose further from a previous euro lifetime record high of 6.29 percent hit at a mid-November sale, but was well below peaks reached earlier this week on the secondary market of
above 7 percent, in the immediate aftermath of the summit.
Italy has trimmed the size of its auctions in reaction to market pressure but it will have to step up issuance in the coming months if it is to meet a gross funding goal of around 440 billion euros next year.
The cost of funding will become a crucial factor in the first quarter of 2012, when Italy has to issue 62.5 billion euros of bonds, said Michael Leister, at WestLB. For now however, the market is happy with supply being digested.
Nearly 26 billion euros of BTP bonds mature on February 1, with 91 billion euros of bonds falling due by the end of April.
ECB buying in the secondary market will help, but, if the crisis worsens, it is difficult to see how Italy will retain independent market access in 2012 and help from the International Monetary Fund may at some stage be needed, Citi analysts said in a note.
The European Central Bank has propped up Italian and Spanish government bonds though purchases on the secondary markets since early August. Analysts say its indirect support has been key in helping purchases by primary dealers at auctions because they can sell at least part of their holdings to the central bank.
Expectations that measures to be agreed at the summit would prompt more aggressive ECB bond buying -- coupled with a new austerity package by the Rome emergency government aimed at staving off financial disaster -- had driven Italian yields lower last week.
But selling pressure returned after ECB President Mario Draghi dashed hopes the central bank would ramp up its purchases in response to the EU agreement on more stringent fiscal rules.
ECB sources told Reuters purchases would remain limited for the time being but analysts say a radical shift may be needed next year if the situation deteriorates.
Bank of Italy Governor Ignazio Visco said last week that Italian borrowing costs must fall in a sustained way to around 5 percent to ensure Rome can continue to manage its 1.9 trillion euro debt.
Spain will also sell bonds this week, with up to 3.5 billion euros of 2016, 2020 and 2021 bonds due for auction on Thursday.
(Reporting by Valentina Za; Additional reporting by William James in London; Editing by Catherine Evans/Barry Moody/Ruth Pitchford)