Fears that Italy, the world's third largest debtor nation, cannot afford its obligations shook world markets, sending investors into the relative safety of the U.S. dollar and Treasurys.
The measure for pain in this latest market drama has been the yield on Italian bonds, which traded above 7 percent for the first time Wednesday, a level viewed as unsustainable by the markets and the level at which Greece, Ireland and Portugalsought help. The warning signs were also flashing when the yield curve inverted, and 2-year yields rose above the 10-year, which was at 7.25 percent.
Italian Prime Minister Silvio Berlusconi said Tuesday that he would resign after the 2012 budget is approved, which sent risk markets rallying. However, the lack of clarity around Berlusconi's exit concerned markets and Italian bonds continued to feel pressure.
"This is getting to be a game changer, will we have a euro one day? The market is forcing that issue much faster than any time in the past. It was one thing when it was about Greece. If you let Italy go off the cliff, you're questioning why do you have a euro in the first place," said Nomura Americas Treasury strategist George Goncalves.
"You cannot allow the Italian bond market, the third largest market, the biggest in Europe, to trade like a high yield market," he said of the $2.2 trillion Italian debt market.
The U.S. bond market was the beneficiary of the fear trade, with 10-year U.S. Treasury yields sliding to 1.92 percent at one point. The dollar index leapt 1.3 points to 77.93, a 1.8 percent increase, as the euro fell towards 1.35.
Stocks fell sharply, with banks in the lead. The S&P financial sector was down nearly 5 percent as the market plunged to new lows in afternoon trading, while the Dow was down more than 400 points.
Meanwhile, Greece, the market's chief source of worry before Italy took center stage, has been moving to restructure its government. But a meeting of political leaders with the country's president was pushed back to Thursday after a deal on a new unity government collapsed. Earlier Wednesday, Greece party leaders were leaning towards house speaker Filippos Petsalnikos to head the country's new coalition government.
Art Cashin, UBS director of floor trading, said the market got even more jittery when the Greek efforts to restructure the government unraveled. "It was more that Greece can't seem to get it's act together, and people realizing this thing Italy is going to vote on isn't even written yet," he said. Traders said the S&P was testing a key support level of 1230.
Rumors swirled through the morning that the European Central Bankwas holding an emergency meeting. The ECB declined comment, but there was also speculation it was in the market buying bonds.
"It's not just Italy. The contagion is spreading. They've got to stop this," said Marc Chandler, Brown Brothers Harriman chief currency strategist. "The French bond spread to the German bund is at a new high. Three month libor is at its highest level in more than a year... All of this is showing rising tensions."
"As soon as Italy announces a new government, Greece announces a new government it will help ease the political tension," said Chandler, adding the markets may then shift focus to the next country in line, Spain.
Chandler said the euro could see more selling and easily get to 1.34.
"Maybe the Treasury market rallies a little more but bonds for the most part have priced in this negativity, but what happens to oil and stocks?" said Goncalves.
"The Fed will be the grown up in the room. If this thing gets worse, then the Fed will step up and do intra meeting easing," he said.
"The authorities should understand the gravity of the situation. If they don't, then they are admitting defeat and the euro will be called into question."
Berlusconi won a budget vote Tuesday but lost his majority, signaling a lack of confidence in his leadership.
Last week, Berlusconi agreed to have the IMF monitor the country's economic reform efforts, as investors became increasingly wary of his government's efforts to rein in costs.
"The authorities should understand the gravity of the situation. If they don't, then they are admitting defeat and the euro will be called into question," said Goncalves.
The rising Italian yields triggered a move by two key clearing houses to raise margin requirements. This would raise the cost for banks that use Italian bonds as collateral to borrow in the secured lending market.
Follow Patti Domm on Twitter: @pattidomm