Political turmoil pushes Portuguese yields to crisis levels
* Portuguese 10-year yields briefly top 8 percent
* Cost of insuring Portuguese debt against default soars
* Italian, Spanish and Irish bonds also fall but by less
LONDON, July 3 (Reuters) - Portuguese bond yields rose sharply, led by shorter maturities, on Wednesday as a government crisis prompted investors to shun the bailed-out country, raising concerns about a renewed bout of euro zone debt trauma.
Stocks on the Lisbon bourse suffered their biggest daily fall in three years and the cost of insuring Portuguese bonds against default rose to its highest since November.
The resignation earlier this week of two ministers threatened to force an election over continued budget austerity, putting at risk Portugal's goal of exiting its 78-billion-euro bailout by returning to regular bond markets next year.
Portugal's bond yields surged to levels near which it was forced to seek international aid two years ago. Two-year yields rose more than 10-year yields - a move that can suggest investor nerves about getting their money back - and brought the yield curve to its flattest since June 2012.
Prices suggested scant liquidity, or money flow, was exaggerating the moves, however.
Euro zone debt markets have been relatively calm since the European Central Bank announced last year that it would step into markets under certain conditions.
Portugal, however, may not meet the criteria as it is not fully back in the bond market yet.
"(The situation) will ... bring back discussion on whether the ECB has any interest in trying to prevent further increases in Portuguese yields," said Elwin de Groot, senior market economist at Rabobank said.
The sell-off extended to Italian and Spanish debt, but was less pronounced there. Investors favoured safety, securing demand at a German auction in line with this year's 1.9 bid-cover average.
Ten-year Portuguese yields surged at one point to 8.2 percent - their highest since November 2012 and were on track for their biggest daily rise since January 2012. They last stood 1 percentage point higher on the day at 7.52 percent, 2 percentage points over their two-year counterparts.
Ten-year yields might struggle at the 8.25-8.27 percent area as it represents the 23.6 percent retracement of the fall from January 2012 to May 2013, Societe Generale strategists said, adding they expect yields to retreat towards 6.90-7.20 percent.
Portugal would have to grow at a 7-8 percent annual rate to be able to afford servicing its debt at these yield levels in the long run, de Groot said. The economy contracted 4 percent on an annual basis in the first quarter.
The difference between the yield implied by prices buyers offered and those sellers wanted to be paid for Portuguese 10-year bonds was last 160 basis points. It suggested very low liquidity. The gap in Italy, by contrast, was just 17 bps.
Ten-year Spanish and Italian borrowing costs rose sharply but held below 5 percent. Ten-year Irish yields rose 8 basis points to 4.05 percent. Ireland is seen as on track to exit its bailout.
Greek 10-year yields surged 55 basis point to 11.73 percent, further inverting the yield curve and suggesting investors see an increased risk of default.
One holder of a small amount of Portuguese debt said he was watching developments to see whether the recent rise in yields was a buying opportunity. He saw a debt restructuring as unlikely and said yields should therefore fall in the future.
"It is probably an exaggeration by the market," said Oliver Eichmann, who oversees 12 billion euros worth of assets as portfolio manager at Deutsche Asset & Wealth Management.
"European officials have made very clear that Greece and Cyprus were an exception and this still holds. Portugal has made important progress in meeting the terms of their deal and European officials will acknowledge that."
Analysts said the tamer reaction in Italian and Spanish debt, although significant, indicated support from domestic investors and faith in the ECB's bond-buying programme.
Threadneedle Investments fund manager Martin Harvey said his firm's global funds had already reduced exposure to Italian and Spanish debt because of concerns over global central bank liquidity, but would stay put for now.
"This is not a systemic issue at the moment," he said.