Spain, Italy in market storm ahead of Greek vote

(MADRID) - Investors pounded Spanish and Italian debt on Tuesday, beset by grave doubts over a Spanish banking rescue and fears of a looming Greek exit from the eurozone.

Despite eurozone powers striking a deal Saturday to extend Spain a banking sector rescue loan of up 100 billion euros ($125 billion), the alarm gripping bond markets showed no sign of relaxing.

Two major concerns stood out: doubts over Spain's outlook even with the mega-loan and this Sunday's Greek elections, which in a worst-case scenario could send Athens back to the drachma.

It was impossible to say how things may turn out, said Edward Hugh, an independent economist based in Barcelona.

"This thing is like an express train accelerating towards the buffers in the station," he said.

"You have got this cocktail now with the Greek elections coming this weekend and talk of capital controls over Greece, you have got Italy coming back into the line of fire and then you have got this uncertainty about Spain."

Spain's benchmark 10-year government bond yields spiked to 6.672 percent and by early afternoon were at 6.656 percent -- a level regarded as impossible to sustain over the longer term.

The nation's risk premium -- - the extra rate investors demand to hold its 10-year bonds over their safer German counterparts -- hit 5.34 percentage points, not far from the euro-era record of 5.48 percentage points struck shortly before the banking rescue.

Markets also punished Italy, at risk of being the next domino to fall in the eurozone crisis as it struggles to boost growth and confronts a public debt mountain of 1.9 trillion euros.

Italy's 10-year government bond yield leapt to a high of 6.197 percent from the previous day's closing level of 6.03 percent.

Far from calming the markets, the rescue for Spain exposed a string of new doubts over the impact on the debt; how it will be implemented; and whether it will be just the first rescue for a nation struggling to cut deficits in a period of recession and sky-high unemployment.

Spain was expected formally to seek the loan at a eurozone finance ministers' meeting June 21, and a final figure would come after a review by the European Union, European Central Bank and IMF, officials said.

A report by Barclays Capital analysts said that a loan of 70-80 billion euros would push up Spain's public debt by 7.0-7.5 percentage points from the end-2011 level of 68.5 percent of economic output.

Under this scenario, Spanish public debt would likely peak at 95 percent of economic output by 2015, they predicted.

Spain's Treasury had sought on Monday to ease concerns over the impact of the rescue loan on Spain's sovereign debt, saying it would "reinforce its overall solvency."

One key concern for bond buyers is whether the eurozone bailout for Spain would tap the incoming bailout fund, the European Stability Mechanism (ESM), whose debt takes priority for repayment over ordinary investors in a time of crisis.

Several analysts warned that a Spanish banking rescue using the ESM, which comes into force next month, could have the unintended effect of scaring ordinary investors away from Spanish government bonds.

"If the amount borrowed from the ESM were to materially exceed the currently expected 100 million euros, the ESM's self-declared preferred creditor status could, in our view, constrain Spain's access to the capital markets and therefore reduce the likelihood of bond holders being paid in full," said Standard & Poor's rating agency.

In Brussels, the European Union's Economic Affairs chief, Olli Rehn, said the eurozone would decide rapidly which of the bailout funds it would tap for Spain's line of credit.

Investors also worried about the prospect of Spanish banks using the new cash to load up on Spain's sovereign bonds, analysts said.

Tiny Cyprus added to the gloom.

Cyprus Finance Minister Vassos Shiarly told journalists on Monday that his country had an "exceptionally urgent" need for a bailout to recapitalise its banks by June 30, according to the Wall Street Journal.

The island's economy is only a 60th of the size of Spain's, it said.

The big spectre, however, remains Greece, and the prospect that anti-austerity party Syriza will win elections on Sunday, refusing the terms of its international bailout and leading possibly to its departure from the single currency.