NEW YORK (Reuters) - Stocks and the euro plummeted on Wednesday as Italian borrowing costs spiked, raising fears that the country will be forced to seek a bailout that could overwhelm the euro zone’s finances and push the region into a recession.
The euro had its worst day against the U.S. dollar in 15 months and investors fled to the safety of U.S. government debt.
Investors are concerned the euro-zone and international lenders would be unable to assemble a bailout big enough for Italy, which is the euro zone’s third-largest economy.
Yields on two- and 10-year Italian bonds rose above 7 percent, a level where the cost of financing a debt burden of more than 2 trillion euros is seen as becoming unsustainable.
“Italy’s latest debt woes signal a new, even more dangerous phase in Europe’s debt crisis,” said Mohamed El-Erian, co-chief investment officer of PIMCO, which is home to the world’s largest bond fund and a holder itself of Italian sovereign debt.
Stocks fell across the board, with the Dow industrials sinking almost 400 points, while banks’ shares were particularly hard hit on fears about their exposure to European debt.
Two major clearing houses raised the level of collateral needed for those holding Italian government debt. The move makes it more expensive for holders of Italian debt to borrow against it and triggers a cycle in which rising yields fuel more fear and more selling.
Above 7 percent, Italian bond yields have reached levels seen as a tipping point. Portugal and Ireland were forced to seek bailouts not long after their sovereign debt surpassed that yield level.
“It is certainly Italian bond yields (rising) that caused the markets to sell off today,” said Troy Buckner, managing principal at NuWave Investment Management, a hedge fund in Parsippany, New Jersey.
“With this picture, all the sovereign debt held by European banks gets re-priced lower as fears continue to rise, which further jeopardizes the European banking system.”
In a measure of perceived risk, the cost to insure Italy’s debt in the credit default swap market rose to a record 571 basis points, up from 520 basis points on Tuesday, according to data provider Markit. This means it would cost 571,000 euros per year to insure 10 million euros of Italian debt for five years.
Greece’s CDS also continued to trade at very distressed levels — at an upfront cost of 59 percent — or 5.9 million euros — to insure 10 million euros of debt for five years, in addition to annual payments of 500,000 euros.
Spanish CDS costs rose 32 basis points to 429 basis points — the highest since late September — and French CDS costs rose 12 basis points to 196 basis points — the highest in a month, Markit data showed.
French banks are more exposed to Italian debt than any other country’s lenders, with more than $416 billion in exposure, according to the most recent data from the Bank for International Settlements.
The exposure of U.S. banks is much smaller, at about $47 billion.
U.S. money market investors scrambled for cash and scooped up U.S. Treasury bills on Wednesday on anxiety over whether Italy could repay its debt.
Key measures of risk aversion rose to levels not seen since last summer, when investors grappled with the initial round of the euro-zone debt crisis.
The search for safety drove U.S. Treasury prices sharply higher, and yields, in turn, kept shrinking. The benchmark 10-year U.S. Treasury note shot up 1-1/32 with the yield at 1.97 percent.
Investors unloaded assets perceived as risky.
The Dow Jones industrial average .DJI fell 389.24 points, or 3.20 percent, to close at 11,780.94. The Standard & Poor's 500 Index .SPX dropped 46.82 points, or 3.67 percent, to end at 1,229.10. The Nasdaq Composite .IXIC lost 105.84 points, or 3.88 percent, to close at 2,621.65.
World stocks as measured by MSCI .MIWD00000PUS dropped 2.7 percent, and U.S. dollar-denominated Nikkei futures fell 2 percent.
Traders said the European Central Bank bought Italian debt aggressively on Wednesday in an attempt to lower yields.
Mark McCormick, a strategist at Brown Brothers Harriman in New York, said the ECB may be forced to increase those purchases or to cut interest rates again next month, all of which is likely to weigh on the euro. The ECB cut rates to 1.25 percent last week.
“All of this is adding to the case for more economic weakness in the euro zone as a whole, and recent manufacturing data suggests things are getting worse,” McCormick said.
The euro hit $1.3547, sliding more than 2 percent versus the greenback, marking its largest percentage drop since mid-August 2010. The single currency dropped 1.9 percent versus the yen and 0.5 percent against the Swiss franc.
Reporting by Rodrigo Campos; Additional reporting by Karen Brettell, Herb Lash, Jennifer Ablan, Steven C. Johnson and Richard Leong; Editing by Leslie Adler, James Dalgleish and Jan Paschal