Italys benchmark borrowing costs have risen above the critical 7 per cent level in a week that will see Rome auction up to 20bn euros of debt.
The bond issues today and tomorrow are the first big market test following the launch of three-year loans for banks by the European Central Bank just before Christmas.
Italy, the worlds third-largest bond market, is seen by many investors as the barometer for the eurozone debt crisis. It faces a crucial opening to the year with auctions of more than 100bn euros in the first quarter alone.
Italy will auction 9bn euros of six-month bills and up to 2.5bn euros of two-year zero-coupon bonds today. Tomorrow sees 5bn-8bn euros of three-year, seven-year and 10-year bonds come up for sale.
Ahead of the auction, Italys benchmark 10-year bond yields inched above 7 per cent in thin trading. Borrowing costs of more than 7 per cent are viewed by analysts and investors as unsustainable; similar yields have forced Greece, Ireland and Portugal into international bail-outs.
But some European politicians, led by Nicolas Sarkozy, French president, have seized on the move by the ECB to offer three-year loans as a way for banks to support governments. In what some in the markets are calling the Sarkozy trade, banks can borrow from the ECB at 1 per cent and then theoretically reinvest the money at 6-7 per cent in Italian government bonds.
Strong demand at an auction of Spanish government bills just before European banks tapped the ECB was attributed to banks stocking up on collateral to use for the loans.
But outside of banks in Italy and Spain, the two countries at the heart of the crisis, analysts have been sceptical about how many financial institutions would take part in the trade. Many European banks such as BNP Paribas and Deutsche Bank have made a big show recently of how much they have reduced their exposure to Italian and other peripheral eurozone government bonds.
Analysts also point to the fate of MF Global, the US broker that went bankrupt in October after placing big bets on Italian and Spanish bonds, as a reason why banks might shy away from stocking up again on government debt.
Italys borrowing costs have begun to diverge away from Spains in recent weeks. Spains 10-year yields fell 3 basis points on Tuesday to 5.35 per cent while Italys rose 5bp to 7.03 per cent, according to Bloomberg data.
Investors turned on Italy in part because of its large debt burden of 1.9tn euros, but also because of the slowness of reforms under the former prime minister, Silvio Berlusconi.
However, a new, unelected technocratic government under the leadership of the former European commissioner Mario Monti has failed to stem the rise in Italian borrowing costs as investors fret about the 350bn euros that Rome needs to raise in 2012. This means that it faces almost daily auctions, making it a potential hostage to any volatility in the markets.
The Financial Times Limited 2011