The euro zone's debt crisis deepened on Tuesday, with investors pushing the single currency lower and the spreads on peripheral bonds up to new highs amid concern weak member states may ultimately be forced to default.
European policymakers came out in force to try to calm markets, with European Central Bank President Jean-Claude Trichet warning that pundits were underestimating the determination of governments to keep the euro zone stable.
But markets paid little attention, pressuring Portugal, Spain and Italy only days after the EU agreed to an 85 bln euro bailout for Ireland.
The borrowing costs of countries like Belgium and France also rose as investors looked beyond the euro zone periphery and targeted core founding members of the bloc.
"The crisis of confidence in Europe can't be resolved quickly," said Rick Meckler, president of investment firm LibertyView Capital Management in New York. "No single event can put things back in order."
A Reuters survey of 55 leading fund management houses showed U.S. and UK investors had significantly cut back their exposure to euro zone bonds this month, piling into equities instead despite a weakening in global shares.
Markets are already discounting an eventual rescue of Portugal although the government in Lisbon denies, as Irish leaders initially did, that the country needs outside aid.
While a Portuguese rescue would be manageable, assistance for its larger neighbour Spain would sorely test EU resources, raise deeper questions about the integrity of the 12-year-old currency area, and possibly spread contagion beyond Europe.
Citigroup Chief Economist Willem Buiter described the turbulence hitting the euro zone as an "opening act" and predicted that sovereign default fears could soon extend to Japan and the United States.
"There is no such thing as an absolutely safe sovereign," he wrote in a research note.
Trichet, speaking at a European Parliament hearing in Brussels, said the bloc needed to regain its sense of direction and move towards a "quasi budget federation" to address concerns about fiscal and economic imbalances.
EURO HIT, SPREADS WIDEN
The euro fell for a third straight day, dipping to a 10-week low of $1.2969 before paring its losses to trade above $1.30 in late European trading. The currency has lost over 7% of its value against the dollar this month.
The yield spreads of 10-year Spanish, Italian and Belgian bonds over German benchmarks spiked to their highest levels since the birth of the euro in January 1999 and the cost of protecting against a euro zone sovereign default surged.
Jitters also hit European banking shares, which were led lower by French banks BNP Paribas, Societe Generale and Credit Agricole on market rumours Standard & Poor's might cut France's outlook.
"There is no reason for concern, no risk," said Francois Baroin, France's budget minister and government spokesman. S&P declined to comment.
Italian officials also scrambled to play down the threat to their economy, the euro zone's third largest, which some economists have labelled "too big to bail".
"Italy's public finances are sound, we are not among the countries at risk," said Treasury Undersecretary Luigi Casero.
Weakened governments in Italy, Ireland and Portugal have deepened the sense of crisis by sowing doubts among investors about their ability to act swiftly and decisively to bring their debt and deficits under control.
Portugal's central bank warned on Tuesday that its country's banks faced an "intolerable risk" if the government in Lisbon failed to consolidate public finances.
The minority Socialist government in Portugal approved an austerity budget for 2011 last week, but is struggling to meet its targets for deficit reduction.
DIVERGENCES
Data released on Tuesday underscored the degree of economic divergence within the euro zone, which represents an increasing challenge to the European Central Bank and its one-size-fits-all monetary policy.
German unemployment fell in November for a 16th straight month while joblessness in Italy jumped and Greek retail sales plunged under the weight of crushing austerity agreed in exchange for its 110 bln euro bailout.
In addition to sealing Ireland's bailout, European leaders approved on Sunday the outlines of a long-term European Stability Mechanism (ESM) that will create a permanent bailout facility and make the private sector gradually share the burden of any future default.
Although private bondholders will not be asked to share the cost of debt restructurings until late 2013, and then only on a case-by-case basis, the mechanism has stoked fears of defaults and so-called "haircuts" down the road.
Some economists believe markets are going too far in targeting Spain and Italy and believe more decisive action from EU leaders would help limit the contagion.
"We believe that policymakers need to shift from a purely reactive stance – in which packages are quickly cobbled together under severe market pressure – to a proactive policy that provides clarity and assurance," economists at Barclays Capital said in a note.
