Contagion risk in Europe is back on the agenda, not even a month after a debt swapthat saw Greece sheltered from a messy default after a second liquidity-boosting operation from the European Central Bank.
Among the euro zone periphery countries, Spain is creeping up again as the big, sick member of the area and a recent rise in Spanish bond yields is a sign that its illness is unlikely to be cured soon, analysts told CNBC.com on Thursday.
Italian 10-year bond yields rose 7.9 basis points on the day on Thursday, to 5.08 percent but they were overtaken by Spanish 10-year bond yields, which were 5.49 percent, up 7.2 basis points on the day according to Reuters data.
On Friday morning, Spanish 10-year bond yields were hovering around 5.47 percent while Italian bond yields were around 5.07 percent.
"It's the contagion risk," Jeffrey Alldis, a trader at ACT Currency Partners in Zurich told CNBC.com.
"It's possible that other countries like Spain, Italy and Ireland want the same thing" as the deal Greece got to restructure its debt, Alldis added.
"We're seeing the expectation of volatility increasing which also tells us that uncertainty is rising," he said.
Spreads of credit default swaps - the cost of insuring against default - were 433.12 for Spain and 376.6 for Italy on Friday morning.
After the European Central Bank's second Long-Term Refinancing Operationon the last day of February, some analysts said that the European debt crisis was over as banks would use the money – lent to them at the bank's record low rate of 1 percent for three years – to buy the sovereign debt of the stricken euro members.
For a while, it looked like the liquidity injection was working.
"Since the second three-year LTRO at the end of February there's been a lot more stability in the euro area banking system as a whole," Stephen Gallo, head of market analysis at Schneider Foreign Exchange, told CNBC.com.
"A lot of the money that was lent by the ECB went into areas such as Italian and Spanish debt," he said.
Analysts at Capital Economics wrote in a market note that the central bank's latest liquidity operations appear to have delayed "a looming disaster in the euro zone banking sector."
"But it would be wrong to think that they have solved the region’s deeper fiscal and economic problems, or secured the future of the single currency itself," they added. "The ECB has administered an effective, but temporary, anesthetic. It is up to the region’s governments to deliver the cure."
Gallo said investors should look to two-year bond yields to see what markets think of the periphery countries, as for most of them the debt is massed towards the short end of the maturity spectrum.
Yields on two-year government bonds were around 8 basis points lower for Italy than for Spain, despite the fact that before Prime Minister Mario Monti took over, Italy was considered a country with more difficulties than Spain and its debt was priced higher.
"If you look at the way short-term Italian yields reacted to the LTRO, it looked like a lot of investors and banks went for Italy," Gallo said. "Italy has better fiscal metrics than a country like Spain, Portugal and obviously Greece… Italy is essentially safe."
"The story in Spain was a huge over-leveraging of private assets. Spain is more vulnerable because of the huge property bubble," he added.
Boom Gone Bust
Spain's construction boom during the golden years before the credit crunch saw thousands of apartments being built while the country imported workers from poorer European Union members such as newly-accepted Romania and Bulgaria to keep up with demand for workforce.
But as the crisis struck the housing market crashed, leaving behind ghost townsand forcing Spain to defy European Union principles by imposing restrictions on the workers from new member countries as unemployment soared to more than 22 percent.
An analyst told CNBC.com earlier this month that Spain was suffering worse problems than Greece because of its dire economic situation.
The country entered a dispute with the European Union over cutting its budget deficit, as the EU wants it to impose harsher austerity than the government is comfortable with.
"The issue is that Spain is a bigger risk to the euro area at the moment… the balance sheets of its banks are just awful," Gallo said.
The "huge bout of austerity" in Europe has people wondering where growth will come from, adding to insecurity about the euro zone, Rob Carnell, an analyst with ING, told CNBC, adding that the LTRO is unlikely to filter through into the real economy, just as the Federal Reserve's quantitative easing did not mean more lending for businesses and individuals in the U.S.
"I wouldn't have thought that you're going to get a big impact on the real economy," Carnell said.
Data on European manufacturing seemed to confirm the gloomy outlook, with the flash composite euro zone PMI declining to 48.7 in March against expectations of an improvement to 49.7, with both manufacturing and services contracting. A number of under 50 shows contraction while anything above it signals an expansion.
Strikes against austerity measures are expected in Spain next Thursday, a day before the government's discussion of the budget.