US debt crisis continues as turmoil infects Italy and Spain

Markets spooked as bond yields in both founder members of single currency hit monetary union records

guardian.co.uk, Tuesday 2 August 2011 21.14 BST

Financial markets in Europe and North America were gripped by a new sense of crisis as the turmoil caused by the narrowly averted US debt default moved back across the Atlantic and infected Italy and Spain – two key members of the eurozone.

Bond yields in both the founder members of the single currency hit monetary union records, forcing Spain's prime minister, José Luis Rodríguez Zapatero, to abandon his holiday plans. Italy responded to a fresh wave of losses in its banking sector by announcing a crisis meeting of economic policymakers.

Interest rates on Spanish and Italian bonds rose to well above 6%, the level that signalled the beginning of the bailout process for Greece, Ireland and Portugal.

Meanwhile, interest rates on assets seen as safer fell sharply, with the yield on UK 10-year gilts dropping to an all-time low of 2.77%. Gold rose to a new record level for a ninth day in a row on Tuesday.

Wall Street's Dow Jones index had lost 266 points by the close in New York – its eighth successive fall and longest losing streak since the global banking system was on the brink of collapse in October 2008.

US shares have given up virtually all their 2011 gains, while stocks in Europe and Asia are already trading below the levels at which they ended 2010.

"There is a growing sense of crisis enveloping markets in the northern hemisphere," said Nick Parsons, the global head of strategy at National Australia Bank.

Amid fears that Italy and Spain will require a financial bailout to bring down their borrowing costs, Bob Diamond, the chief executive of Barclays, said Europe's sovereign debt crisis, and woes in the US, justified the UK's new reputation as a "safe haven" amid the turmoil.

Diamond warned that the single currency's problems were not going to disappear – which he dubbed "chronic event risk", and said it was important to support David Cameron and George Osborne's efforts to put Britain's public finances back on track.

"If they don't address public spending they put at risk the [UK's] triple A rating. If the US gets downgraded, it is an issue for the US but it is still a relatively minor market event. But if the UK gets downgraded, it would have bigger implications for the economy," said Diamond. "I do support what the prime minister and the chancellor here are doing."

Diamond's intervention came as the US Senate voted for the deficit reduction plan agreed by Democrats and Republicans in Washington and as Fitch, one of the world's three big rating agencies, gave the US a breathing space by saying it would not immediately strip the world's biggest economy of its prized top-notch credit ranking.

Fitch stressed, however, that the respite could be shortlived. While pointing out that the risk of default was "extremely low", the rating agency said that without significant changes in fiscal policy, the US debt to gross domestic product ratio "will reach 100% by the end of 2012, and will continue to rise over the medium term – a profile that is not consistent with the United States retaining its triple A sovereign rating".

BNP Paribas bank was on Tuesday forced to take a €534m hit against its exposure to Greek government debt. The bank insisted it would be a one-off occurrence despite a large exposure to Italy, in the latest sign that banks across Europe are beginning to take hits against the country. HSBC set aside £65m on Monday.

Confirmation of the US debt deal prompted a fresh political row in the UK, with the government insisting the spending restraint agreed to by Barack Obama was tougher than that announced by George Osborne.

Conservative MPs said the US deal vindicated the coalition's approach and represented a setback to the shadow chancellor, Ed Balls, who has been urging the UK government to adopt the more cautious approach to deficit reduction hitherto favoured by the US.

Labour sources disputed that America's programme of cuts was now more draconian than Britain's and said the Republicans appeared to have forced Obama into "a plan that some believe risks going faster than is economically wise, just at the time when worries are growing about the fragility of the US recovery".