Markets are likely to keep up the pressure on Italy and Spain in a flight to quality as investors realize the euro zone's debt crisis is not going away and with the European Central Bank again the only authority that could act quickly to reverse the market trend, analysts told CNBC.com Tuesday.
Yields on Italian bonds hit an euro lifetime high on Tuesday, reaching parity with Spain's as worries about sovereign debt hit the euro zone's second-largest debtor. Italy's stock market index closed at the lowest level in more than 27 months, with banks exposed to Italian debt plummeting.
There was no particular news that triggered investor worries, rather the slow realization that a euro zone summit last month did not do much to solve the crisis, economists said.
"This isn't anything new," Peter Dixon, senior economist at Commerzbank Securities, told CNBC.com.
Markets looked at the details of a resolution from a summit of euro leaders two weeks ago where it was agreed that Greece's debt burden will be relieved by cutting interest rates on loans from the European Financial Stability Facility (EFSF) and extending the maturity on the debt and saw that "this really puts [a] sticking plaster over the Greek wound," Dixon added.
Sentiment had been reversed only temporarily in the past week by the focus on the US debt problems; but the news last week of new elections in Spain, coupled with that on Tuesday about emergency meetings by Italian authorities to deal with the market turmoil, have stoked investor fears, Carsten Brzeski, euro zone senior economist at ING, told CNBC.com.
"There is uncertainty, a lack of trust and confidence in sovereign debt, there are not many safe havens left," Brzeski said.
ECB Only Salvation?
As investors pored over the details of the second bailout for Greece, they looked at whether the EFSF would have enough firepower to bail out Spain and Italy – and they didn't like what they saw, analysts said.
"Right now the ECB seems to be the only European player who could act quickly," Brzeski said.
"I think central banks have to be very careful; they don't want to bet against the markets and lose."
The central bank has not bought bonds from distressed euro zone member states for months, but some in the markets are saying it will probably do so.
"If the rise in yields continues, the likelihood of ECB intervention increases significantly," Anders Moller Lumholtz, an analyst with Danske Bank, wrote in a market note.
But it would not be easy for the central bank to take such a decision as the amounts involved would be significantly higher for Italy or Spain than they were for countries such as Greece and Ireland, according to Brzeski.
The ECB bought a total of around 75 billion euros ($106.5 billion) worth of bonds from Greece and Ireland, and Greece's outstanding debt is around 350 billion euros, while there is 1.5 trillion euros worth of Italian debt out there, he explained.
"The ECB was set to close this chapter [of bond-buying], I don't think it would re-open it without a pain in the stomach," Brzeski added.
No Monetary Easing
Another option to stem the rise in yields would be for authorities to reach a gentleman's agreement with domestic commercial banks to purchase bonds, he said. But they may be reluctant to buy more bonds as shares of banks holding Italian debt tanked on Tuesday.
Despite the turmoil, investors should not expect the ECB to announce a reversal of its monetary tightening on Thursday at the bank's monthly meeting on rates, Dixon said. "Once they started the monetary tightening process, there is no way the ECB will admit they got it wrong."
Analysts said they did not expect announcements regarding bond purchasing on Thursday, despite the volatility.
More likely, the bank will try to push the debt problem back to governments, a position it has taken since the onset of the crisis despite its repeated interventions, especially since central bank meddling does not always reverse a market trend.
"I think central banks have to be very careful; they don't want to bet against the markets and lose," Dixon said.
In terms of the countries themselves, Spain despite its problems in mortgage markets and in some savings banks is not faced with a systemic banking problem like Ireland had, he added.
Italy has been living with a high debt to gross domestic product ratio for the past 20 years, according to Dixon, but for the past two years there has been a feeling that politics was stalling economic reform.
"Maybe the markets will look more kindly upon Italy if there was a change of government," he said.