Italian government borrowing costs rose on Tuesday on signs that Rome will need to use public money to avert a new crisis in its banking sector. Rising yields on Italy's government bonds hauled equivalents in Southern Europe higher while safe havens around the world were in demand. Ten-year US yields hit a record low and Swiss yields on 50-year bonds fell below zero for the first time.
The ECB on Monday opened the door to state aid for euro zone banks as Italy negotiates a controversial plan to recapitalise lenders and allow them to work through a mountain of bad debt which has been weighing down their books for nearly a decade. Italy's third-largest lender Banca Monte dei Paschi di Siena, has been at the centre of concerns after the ECB on Monday asked the bank to slash its bad debts by 40 percent over three years, while stress tests at the end of this month could unveil wider issues in the sector.
A bank bailout fund Atlante, set up using mainly private cash, is increasingly seen as insufficient to tackle the problem. "People are now looking at the government to step in and that is the channel by which government bonds are being affected," ING strategist Martin van Vliet said.
Italy's 10-year government bond yield rose 3 basis points to 1.19 percent, away from one-year lows hit on Friday as the economic shockwaves from Britain's vote to leave the EU raised expectations for more central bank easing in Europe. Spanish and Portuguese equivalents also rose 3-4 bps to hit 1.19 percent and 3.03 percent. German equivalents - the euro zone benchmark - fell 2 bps to minus 0.16 percent, near a minus 0.169 percent low hit just after the Brexit vote last month, while US equivalents struck a new record low of 1.378 percent.
Shares in Monte dei Paschi fell nearly 10 percent, making it the biggest faller on the STOXX 600 index. The Italian banking index steadied slightly after a 4 percent slide on Monday, but has shed 55 percent so far this year. In a research note titled 'new banking crisis in Italy?', DZ Bank's Birgit Figge said that concerns around Monte dei Paschi's bad loans had prompted investors to take profits on peripheral bonds that had appreciated sharply last week on ECB easing bets.
Any potential hit to Italy's public finances comes at the worst possible time for the bloc's third largest economy which faces political uncertainty and slower growth in the months ahead. Prime Minister Matteo Renzi has started a campaign to win an October referendum on constitutional reform, aimed at ending Italy's history of unstable governments. But the stakes are high - if he loses, Renzi has said he will stand down. Meanwhile, data from Italy's statistics bureau on Tuesday showed the country's modest economic growth looks to be slowing further without even taking into account the shock caused by Britain's vote last month to leave the European Union.