Borrowing costs jump for fragile euro zone states

By John Geddie

LONDON (Reuters) - Borrowing costs for some of the euro zone's most highly indebted southern states shot higher on Thursday, as fears of slowing global economic growth wounded confidence that the European Central Bank could avert another debt crisis in the bloc.

Greek government bonds were the hardest hit as a sell-off gripped financial markets for a second day, with 10-year yields rising to nearly 9 percent, while Spain missed its target at a bond auction due to weak demand from investors.

With stocks volatile and oil prices plunging, investors sought refuge in safe-haven German bonds, pushing yields on the euro zone benchmark to record lows.

ECB President Mario Draghi helped to end the last euro zone crisis by promising two years ago to do whatever it takes to save the euro. This brought down borrowing costs of countries such as Greece, which was bailed out by the European Union and IMF, and Spain, which took EU aid to rescue its banks.

Interest rate strategists urged caution on Thursday but noted a risk that investors would increasingly start to question whether the ECB would resort to its ultimate policy weapon for averting a crisis - buying government bonds.

"It's early days ... but if the market loses faith in what monetary policy can do to fend off falling global growth and the risk of deflation, then it could become a much more serious issue," KBC rate strategist Mathias van der Jeugt said.

In the biggest two-day sell off since July 2012, Greek 10-year yields shot up another 100 basis points (bps) to 8.85 percent on Thursday.

Greece has aimed to ditch its unpopular programme with the EU and International Monetary Fund, which demanded severe austerity, and return to relying on markets to raise funds.

However, its euro zone partners told Reuters on Wednesday that Athens was changing its mind about giving up their financial help next year, as bond investors once again closed the door on the serial defaulter.

To ease the effects of the market turmoil on Greek commercial banks, the ECB has reduced the "haircut" or penalty it applies on the bonds they post as collateral to borrow funds, a Greek central bank official told Reuters on Thursday.

Compared with Germany, the premium or "spread" that Greece pays to borrow over 10-years was the highest in more than a year. Italy's was at eight-month highs, Portugal's at seven-month highs and Spain's at five-month highs.

Italian and Portuguese 10-year yields were up 30 bps at 2.70 percent and 3.60 percent respectively, while Spain's were up 28 bps at 2.38 percent. By contrast Bunds, the German equivalents, dropped 5 bps to a new low of just 0.716 percent.

In Thursday's auction Spain sold only 3.2 billion euros ($4.09 billion) of debt due to weak demand, falling short of the top end of its target amount.

"(This is) the first time I can remember this happening in quite some time ... This weakness is unsurprising given the very chunky increase seen in all euro zone spreads versus the Bund this morning," said Lyn Graham-Taylor, a strategist at Rabobank.

French five-year bonds sold at a new record low yield at an auction as investors took shelter in liquid, high-rated debt, but in secondary markets its yields were up 6 bps at 1.2 percent.

OPPOSING VIEWS

Market jitters were made worse by a rift in Brussels as France and Italy present 2015 budgets that appear to break EU targets.

German Chancellor Angela Merkel told parliament on Thursday that Europe must cut public deficits and improve competitiveness because the euro zone debt crisis had not yet been overcome and its causes had not been eliminated.

There is also a debate in Europe's top court over whether the ECB's promise to buy euro zone government bonds if this were needed to save the euro would breach of its mandate and amount to direct monetary financing of governments.

If the challenges made by German lawmakers are upheld, it would probably torpedo an ECB programme to buy government bonds that investors are depending on.

"The ECB only has one card left to play and it doesn't look imminent," said one government bonds trader.

(Editing by Louise Ireland; editing by David Stamp)