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 Portugal sought 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.
Stocks fell sharplyin Europe and the U.S., with banks in the lead. German and French equity markets were both down 2.2 percent.
In the U.S., the Dow had its worst day since Sept. 22, losing 3.2 percent to 11,780. The S&P 500 fell 3.7 percent to 1229, just below a key support level, and the S&P financial sector was the worst-performing major sector, down more than 5 percent.
The U.S. bond market was the beneficiary of the fear trade, with 10-year U.S. Treasury yields sliding to 1.95 percent, in an inverse move to bond prices. The dollar index leapt 1.26 points to 77.85, a 1.7 percent increase, as the euro fell towards 1.35.
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 Financial director of floor trading, said the market got even more jittery when the Greek efforts unraveled. "It was more that Greece can't seem to get its act together, and people realizing this thing Italy is going to vote on isn't even written yet," he said.
Rumors swirled through the morning that the European Central Bankwas holding an emergency meeting. The ECB declined comment, but there was also talk it was in the market buying bonds.
"I think the view has been the 'big bazooka' has been the ECB's balance sheet which can buy an unlimited amount of Italian paper. It will not happen without strings attached which means the ECB will only do that if it is effectively in control of the Italian government," said Amitabh Arora, head of asset allocation research at Citigroup.
"I would make a further prediction if Italian yields stay here, we'll see a further deterioration in risk assets," he said. Arora said ECB bond purchases of $10 to $15 billion a week could stem the rise, but it is not a likely outcome.
ECB official Juergen Stark added to the tension Wednesday afternoon, when he warned European governments not to ask for support from the ECB, making it the lender of last resort.
"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.
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