The euro rose and European shares reversed earlier losses to gain for a third straight day on Tuesday, relieved by Italy's success in selling 7.5 billion euros in bonds even if its cost of borrowing continues to soar.
Europe's third-largest economy paid record yields of nearly 8 percent to sell three-year paper, a level that is likely to see its debt burden spiral out of control if sustained over time. It also sold a 10-year bond at a euro lifetime high of 7.56 percent, up from 6.06 percent at the end of October.
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But the amount sold was close to the upper end of its target ahead of the sale, easing nerves among investors who had been worried by the prospect of limited demand or yields sharply higher than market levels.
"All in all ... not bad at all," said Marc Ostwald, strategist at Monument Securities. "They sold what they wanted to sell, and most importantly ... the actual average yield levels were all lower than market levels... Great relief, it's all done."
The FTSEurofirst 300 extended gains into a third straight session and was up 0.5 percent at 945.98 while the euro rose 1 percent against the dollar to $1.3435.
The Italian/German 10-year government bond yield spread tightened to 504 basis points from intra-day highs of 523 bps, while German Bund futures fell to session lows of 133.38 after the results were published.
Despite the bounce, sentiment was fragile towards euro zone assets with a report that Standard & Poor's could cut France's triple-A rating outlook to negative within days bringing the focus back to how the debt crisis threatens to ensnare larger economies.
Finance ministers are set to agree details on Tuesday on how to bolster the European Financial Stability Facility bailout fund in a bid to stem contagion in bond markets.
Officials say Germany and France are working on proposals for a more rapid fiscal integration in Europe ahead of an EU summit on Dec. 9, but Berlin is resisting pressure for the European Central Bank to take a more aggressive role in battling the crisis.
Analysts say without a more permanent wealth transfer mechanism the market is likely to be left disappointed by talk of a greater fiscal union, especially if the stance of the ECB remains unaltered. That could see the euro and riskier currencies under renewed downward pressure.
"The bounce has not been that big so far so we might see a bit more short covering but I am still bearish on euro/dollar because I think the euro zone situation is still clearly very serious," said George Saravelos, G10 FX strategist at Deutsche Bank.
Tension in euro zone money markets and banks' reluctance to lend to each other has also grown. This is likely to see investors cut exposure to the euro zone and seek safer alternatives like dollar assets.
Reflecting global market strains, the Bank of Japan supplied dollars in market operations for the fourth time this month on Tuesday, providing $100 million in an operation maturing in three months and $1 million maturing in a week.
Euro zone banks' demand for ECB weekly funding hit a new two-year high, data on Tuesday showed.