MILAN (Reuters) - The main measure of Italy's borrowing costs broke above 6 percent for the first time in 14 years before easing back on Tuesday as the euro zone's third-largest economy was sucked into the bloc's debt crisis.
Italian 10-year yields at one stage soared more than 30 basis points on the day to leap above 6 percent -- the highest since 1997 -- getting closer to the 7 percent level most market players see as being unsustainable for Italy's borrowing costs given its huge debt pile.
The cost of insuring Italian debt against default also rose as prolonged efforts to agree a second bailout for Greece, where the crisis began, eroded investor confidence in policymakers' ability to hold the bloc together.
Analysts said confusion over the Italian government's deficit-cutting 40 billion euro ($57 billion) austerity package and fears it may be watered down by parliament are adding to investors' concerns and making the country an easy target for those looking to hedge against the sustainability of the euro.
"Basically we believe Italy is being used as a liquid proxy on a euro-break up view," Credit Suisse First Boston analysts said in a research note.
The 10-year yield later eased to 5.6 percent, lower than its level of 5.7 percent at Monday's close but still 60 basis points higher than where it stood a week ago.
The premium investors demand to hold Italian debt instead of German paper hit a euro lifetime high of 353 basis points before falling back to just below the 300 threshold.
The 10-year bond yield began to fall back after the Treasury managed to sell 6.75 billion euros of 12-month bills, although risk-averse investors demanded a high price to pick up the paper.
At 3.67 percent, the auction's gross yield was the highest since September 2008, when benchmark interest rates were much higher than they are now.
"Italy is by far the country with the greatest sensitivity to rising debt servicing costs and particularly in terms of rolling over debt. This is not a situation it can afford to have going on for any sustained period of time," said Marc Ostwald, strategist at Monument Securities in London.
Italy has one of the world's highest levels of public debt. At around 120 percent of gross domestic product, it is second only to Greece in the euro zone. A total of 176 billion euros in Italian government paper will come due by the end of the year.
Still, markets breathed a sigh of relief that Rome was able to place the full amount of short term bills on Tuesday. A more challenging test of Italy's ability to fund itself will be on Thursday when it offers between 3 billion euros and 5 billion euros of long-term BTP bonds.
UniCredit (CRDI.MI) and other Italian banking shares, which have born the brunt of a three-day market sell-off because of their vast government debt holdings, reversed early losses in very volatile trading, pushing the blue-chip index into positive territory.
"The positive outcome of the auction has given some relief to markets and spreads are narrowing," a Milan-based trader said.
UniCredit shares - which have fallen 26 percent over the past six sessions -- were up 5.2 percent at 1425 GMT after being suspended for excessive losses. The blue chip index gained 0.75 percent after dropping nearly 4 percent shortly after the open.
Traders also cited talk that the European Central Bank was buying Italian and Spanish paper to stem the losses although bond traders who usually see those transactions said they had not spotted such trades.
Another factor supporting the market was news that Economy Minister Giulio Tremonti was rushing back to Rome to wrap up the austerity budget.
Despite its high debt and anemic economic growth, Italy had long seemed exempt from the turmoil sweeping euro zone peers like Greece, Ireland and Portugal.
But with problems mounting for Athens, markets have started to question the longstanding assumption that Italy's relatively modest budget deficit, its conservative banking system and its high level of private savings would keep it out of trouble.
"There's a confidence problem. What is happening is a collateral effect of the Greek crisis, but there's also a problem of confidence toward the Italian government," said Armand de Coussergues, fund manager at investment management firm Financiere de l'Echiquier in Paris.
"For the current confidence crisis to ease, you would need two things: first, that the Greek crisis gets resolved, that will have an immediate effect on Italian spreads. But we also need more confidence vis-a-vis the Italian executive."
Prime Minister Silvio Berlusconi, weakened by corruption and sex scandals, called on the government and opposition to unite to pass the tough debt-cutting measures.
Additional reporting by Michel Rose, Ian Simpson, Valentina Za in Milan; Emelia Sithole and government bond team in London; Editing by Ruth Pitch ford