Stocks plunge as Italy's interest rates spike over 7%

NEW YORK -- U.S. stocks fell sharply in early trading Wednesday as there were growing signs that Europe's debt crisis has infected Italy, third-largest economy in the 17-nation eurozone.

The Dow Jones industrial average fell more than 300 points in morning trading, before recovering some of that loss. At noon the Dow was off 230 points or almost 2%.

Sparking investor fears was a spike in the yield on Italy's 10-year government bond, to almost 7.5%, a level that raised concern on Wall Street because similarly high yields led to financial bailouts of other highly indebted eurozone countries the past 18 months.

"In our view, 7% is a 'tipping point' for any large debt-laden country and is the level at which Greece, Portugal and Ireland were forced to accept assistance," Rod Smyth of Riverfront Investment Group told clients in a note this week titled "Europe's attention turns to Italy."

The big risk all along in the Europe debt crisis is that it would spread to the bigger European economies, such as Italy and Spain. Now, investors who have lost confidence in Italy are dumping its bonds, which is causing rates to rise, pushing Italy's borrowing costs to rise to dangerous levels. The risk for Italy is they could be effectively locked out of raising capital in public markets.

Europe stock markets fell sharply, with losses of around 2% in France, Germany and the United Kingdom. Italian shares fell almost 4%.

Investors in the U.S. fear the latest problems in Europe will further boost anxiety in global financial markets. They also worry that it will put more pressure on Europe's banks and increase the odds of the eurozone falling into recession. Such a slowdown would crimp sales and profits of U.S. businesses that do business in Europe.

Italian sovereign bonds spiked above the key 7% level — a record — because of the political uncertainty after embattled Prime Minister Silvio Berlusconi said Tuesday that he would resign after parliament passes next year's budget, which includes severe austerity measures.

Part of the spike in yields was due to the fact that brokers raised margin requirements on Italian government bonds . Higher margin costs dampen demand for the bonds and may force some investors to sell.

"The surge in Italian government bond yields has catapulted the eurozone crisis into a dangerous new phase," John Higgins of Capital Economics said in a note to clients early Wednesday.

Most analysts say Italy's current borrowing costs are unsustainable. Yields on Italian government bonds have risen despite buying by the European Central Bank. Analysts say the ECB must get more aggressive if Italy's problems are to be contained and a default avoided.

But the risks of bond yields in Italy spiking further is real. Within a month of Greek 10-year bonds hitting the 7% threshold in April 2010, they reached 12%, prompting a bailout. Similarly, a month after Ireland's 10-year bond hit 7%, it hit 9%, necessitating a bailout there.

The spike in fears about Italy's government debt, which is roughly $2.6 trillion, comes at a time when markets have been whipsawed by confusion surrounding the proposed plan to bail out Greece.

Many analysts say Italy is too big too bail out, but also too big too fail, a situation that adds to the market's anxiety.

"While Italy is considered to be too big to fail, she may be too big to save unless there is a major change of attitude towards resolving the crisis," Higgins said. "Things could be about to turn ugly."