European shares and the euro fell on Tuesday as investors renewed selling of Italian and Spanish bonds, while a sharp rise in French yields pointed to a growing risk that the two-year debt crisis may spread to one of the region's big two economies.

Any relief from the ongoing formation of technocrat-led governments in Italy and Greece has proved short-lived with investors seeking safe-haven assets like German bunds, the Japanese yen and to a lesser extent the U.S. dollar.

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 will still need to be convinced.

Italy's 10-year bond yields approached 7 percent, also pushing Spanish 10-year yields 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 510 basis points. Particularly worrying in recent sessions has been the rise in French bond yields -- over 30 basis points in 10-year yields in the last week.

French banks are among the biggest holders of Italy's more than 2 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.

The cost of insuring against a default by France was up 15 basis points at 215 basis points on Monday, serving a grim reminder that one of the biggest economies in the region would come under the scanner of bond market vigilantes.

European shares fell in early trade, extending the previous day's losses. The FTSEurofirst 300 <.FTEU3> index of top European shares was down 0.6 percent at 969.83 points after losing 0.9 percent on Monday.

The real drivers of this market are the bond yields, said Frederic Rozier, fund manager at Meeschaert Wealth Management, in Paris.

Spain's ability to address its debt issue is being tested by the market right now, though record spreads between Bund yields and the French, Spanish and Italian yields are also due to the fact that Bund yields are dropping.

Even non-German triple-A rated issuers saw premiums over safe-haven Bunds mark new highs on Tuesday as a change of government in Italy failed to ease the euro zone debt crisis.

Investor are awaiting the influential ZEW German business sentiment survey. Earlier, Germany and France posted solid growth in the third quarter but euro zone countries at the sharp end of the debt crisis were faring much worse.

EURO LOWER, GERMAN BUNDS RISE

Sharp downturns in financial markets have raised the urgent need for recapitalization 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 after a rise in peripheral bond yields underscored the challenges facing European leaders.

The euro fell 0.35 percent to $1.3533. The single currency is now near the lower end of its trading band since late October of $1.3484 to $1.4248.

There is no doubt that Europe is nowhere near a situation that can be viewed with optimism, Junya Tanase, chief FX strategist at JP Morgan in Tokyo said. The bias is toward risk-off with both the dollar and the yen rising.

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 57 ticks higher at 138.83 with benchmark 10-year yields down two basis points at 1.768 percent.

(additional reporting by Kirsten Donovan and Blaise Robinson; Editing by Patrick Graham)

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