Financial markets will again be put to the test Wednesday by developments in Italy, which investors fear could drag down the world economy if it does not get its fiscal house in order soon.
"Greece was a nuisance. Portugal was a nuisance, but Italy is not a nuisance. It is a really big deal," said Peter Boockvar, Miller Tabak strategist. Italy, the third biggest debtor nation, has drawn the attention of world markets because investors do not see its government as taking seriously enough the need to rein in costs.
Worries over Italian bonds took a bite out of European markets Wednesay, which began their day higher but reversed gains as the yields on Italian bonds soared to euro-era highs across the curve.
The yield on the benchmark 10-year Italian bond surged to an intraday high of 7.453 percent, well above the 7 percent boundary that in effect prompted Greece, Ireland and Portugal to seek outside financial assistance as their cost of borrowing became too much.
Prime Minister Silvio Berlusconi received approval in a budget vote but lacked the majority that would have signaled confidence in his leadership. But that news wasn't enough to maintain markets' positive momentum in Europe.
News from Greece was secondary Tuesday, even as the country moved towards formation of a new interim government, expected to be headed by former European Central Bank vice president Lucas Papademos.
U.S. stocks rallied Tuesday after Berlusconi committed to leave office after the 2012 austerity budget is approved. Italian bond yields, meanwhile, flirted with 7 percent, a level the market views as psychologically important because that is a level where Greece, Ireland and Portugal all sought bailouts. The 5-year was at 6.80, slightly above the 10-year.
The Dow rose 101 to 12,180 and the S&P 500 rose 14 to 1,275. The U.S. 10-year was yielding 2.06 percent.
"Europe is driving the bus," said Boockvar. "The market has compressed its time horizon to such an extent that they're taking the attitude of, 'Just give me good news. I'm going to buy." And anything that upsets the apple cart, they'll sell."
He said the big test for markets will be when Italian bonds begin trading again Wednesday. "They were closed when the news came out today... If you see a little bounce in Italian bond (yields), this market has the potential of going straight back down again," Boockvar said.
Robert Sinche, RBS global currency strategist, said the markets were also fixated on the Italian 10-year spread versus a AAA blend of European sovereigns. Investors are concerned that when the spread reaches 4.50 percent it could trigger a change in margin requirements by LCH Clearnet for Italian bond holders. RBS reports the spread rose to 4.40 after starting Tuesday at 4.20.
"4.50 is supposed to be the trigger level. There is some talk they might change their criteria," said Sinche. "At the margin, you'd think it would reduce some of the attractiveness of holding that stuff."
What Else to Watch
Chinese inflation data early Wednesday could be important, as the first of several major economic reports from China this week.
There is U.S. wholesale trade data for September at 8:30 a.m. ET. The Treasury auctions $24 billion 10-year notes at 1 p.m.
Earnings reports are expected from Anheuser Busch, General Motors, HSBC Holdings, AngloGold Ashanti, Computer Sciences, Dean Foods, Enbridge, Wendy's, Ralph Lauren and SodaStream before the bell. Companies reporting after the bell include Cisco, Green Mountain Coffee, Lionsgate and Advanced Auto Parts.
Fed Chairman Ben Bernanke makes welcoming comments at the Fed's conference on small business and entrepreneurship at 9:30 a.m. ET. Treasury Secretary Tim Geithner attends the 2011 Asia Pacific Economic Cooperation meeting of finance ministers in Hawaii. Fed Gov. Daniel Tarullo speaks at 12:14 p.m. in New York on current issues in financial regulation.
Your Money, Your Vote
Last but not least, the Republican presidential debate will be live on CNBC at 8 p.m. ET from the campus of Oakland University in Rochester, Mich.
Follow Patti Domm on Twitter: