LONDON Ten-year Italian government bond yields fell sharply on Friday with markets relieved at the prospect of a new government being formed in Italy, but some were skeptical even a passing of an austerity vote would lure investors back into Italian bonds.
Italy's Senate is due to vote on Friday on austerity measures demanded by the European Union to avert a euro zone meltdown, paving the way for a new emergency government to be formed within days.
Europe's third-largest economy has overtaken Greece as the focus of the euro zone debt crisis this week, when yields on Italian benchmark 10-year bonds rose as high as 7.5 percent -- levels considered unsustainable.
Analysts fear Italy's potential inability to fund itself could be a systemic risk given the size of its economy and its government debt, the third-largest in the world.
Ten-year yields fell 27 basis points to 6.7 percent. Traders said they had not seen any ECB buying and that liquidity was thin with some of Europe closed and the U.S. bond market shut for Veterans Day.
"It's a new day, but it's still all the same problems," Rainer Guntermann, strategist at Commerzbank said.
He expected the austerity vote to go through but said this may not be enough to restore market confidence.
"If they would deliver a bit more austerity, even a balanced budget next year or so, it would still be questionable whether this would convince investors to buy again into Italian debt," he said, adding he was skeptical that this selling pressure would go away toward year-end.
The 10-year Italian/German bond yield spread tightened more than 30 basis points on the day to 487 basis points, while the Spanish equivalent was 7 bps tighter around 403 bps.
A third trader said the sell-off this week in Italian bonds had been fueled by real money sellers who have to liquidate their positions beyond certain levels.
"By and large what we have seen here has been ... forced sellers, technical sellers as yields have pushed through the 7 percent handle and the only person who stepped in have been either the ECB directly through the SMP (security markets program) or the local central banks which are also part of the ECB program," the trader said.
He was not convinced about the prospects for Italy.
"We need some sort of political consensus -- a technocrat isn't going to bring that to force through the real measures that they need," he added.
Despite the momentary relief and the tentative progress made in Italy and Greece, whose prime minister-designate will name a new crisis cabinet on Friday, the underlying backdrop remained supportive for perceived safe-haven debt.
German Bund futures shed 45 ticks to 138.10 and 10-year German government bond yields rose 2.9 basis points to 1.80 percent, but Guntermann said they could test new lows as early as next week.
There are fears that things have gone too far, and that even a new Italian government cannot do enough on austerity to restore market confidence.
In the meantime, there is pressure on the European Central Bank to hold the fort and keep buying bonds in the secondary market, even though it has said the program is temporary.
There are also some doubts over when and how effective the euro zone rescue fund will be in taking over that mandate, after the deterioration of the debt crisis eclipsed the impact of an agreement on a euro zone rescue deal in late October.
The head of the euro zone's rescue fund Klaus Regling believes this week's market upheaval in Europe has made it difficult to increase the bloc's 440 billion euro bailout fund to 1,000 billion, the Financial Times reported on Friday.
"Given how far we have widened out in some of these peripherals we can have maybe two or three days of calm -- in inverted commas -- but nothing has really changed underneath," one of the traders said.
"You can see how nervous the market is by the way it reacted to this erroneous French stuff yesterday," the trader added.
Standard & Poor's mistakenly announced the downgrade of France's top credit rating on Thursday, contributing to a sharp rise in the country's 10-year bond yields. S&P later said the message resulted from a technical error and not from any action it intended to take against France.
French 10-year government bond yields were 7.3 basis points lower at 3.41 percent.
(Reporting by Ana Nicolaci da Costa; Editing by Catherine Evans)