European stocks fell and the euro hit a seven-week low on Friday, as record borrowing costs for Italy stoked fears the lack of a comprehensive policy response to the spiralling euro zone debt crisis would lead to a break-up of the currency bloc.
Italy paid a euro-era high 6.5 percent to borrow over six months, almost double the yield at a similar sale a month ago and much higher than market yields ahead of the auction.
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It raised the full 10 billion euros planned but borrowing costs for Europe's third-largest economy remain unsustainably high despite the appointment of an emergency government in Rome to undertake reforms and rein its massive debt.
"Judging from the reaction in (the euro) and Bunds, this is about as weak as the market was expecting," said Peter Chatwell, rate strategist at Credit Agricole CIB.
"Today's auctions indicate that conditions for euro-sovereign supply are still extremely poor, boding ill for the market ahead of next week's bond market supply."
Italian two-year government bond yields rose above 8 percent while the interest rate premium investors charge Italy to borrow over 10 years compared to equivalent German debt continued to rise despite reported buying by the European Central Bank.
German Bund futures also extended losses, reinforcing fears that debt contagion is starting to hurt the region's soundest economy. Bund futures hit a session low, continuing to fall after a sharp sell-off in the wake of a weak 10-year bond auction on Wednesday.
European stocks lost ground for the ninth time in 10 sessions and were on course to post their biggest weekly loss in two months. The FTSEurofirst 300 index of top European shares was down 0.7 percent at 893.57 points.
It has lost about 13 percent since late October as investors fret over the slow pace of efforts to contain the debt crisis and Germany's persistent opposition to the idea of joint euro zone bonds and an expanded role for the ECB.
French President Nicolas Sarkozy and Germany's Chancellor Angela Merkel, after talks with Italian Prime Minister Mario Monti on Thursday, agreed only to stop bickering in public over whether the ECB should do more to resolve the crisis.
A growing concern in the past month has been signs of stress in the bank-to-bank lending markets which were at the heart of the financial sector turmoil three years ago.
Funding problems for European banks have escalated, with the cost of swapping euros into dollars in the currency swap market reaching three-year highs of 157 basis points on Friday.
The ECB is looking at extending the term of loans it offers banks to two or even three years to try to prevent the euro zone crisis precipitating a credit crunch that chokes the bloc's economy, people familiar with the matter say.
The euro extended losses and fell to a fresh seven-week low against the dollar, dropping to $1.3240 and down 0.8 percent on the day.
"Merkel sees no scope for euro bonds and the ECB continues to make it clear it sees no scope for financing public debt," said Manuel Oliveri, currency strategist at UBS in Zurich.
"Without agreement on either of those two factors there is not much chance of an improvement in sentiment towards the euro and we think it can go lower from here still."