Italy, Spain plunge on fresh contagion shocks and fears

Now that European central bankers have all but admitted Greece may need to default on its debt after all, traders are headed for the doors in Spain and Italy.

The price of insuring Spanish and Italian bonds from default risk soared again today relative to the German debt that traders consider the safest investment in the euro zone.

The gap, or “spread,” between what it costs to insure Spanish debt and the equivalent German debt jumped 4.5%, while in Italy spreads reached record levels, forcing the Milan credit market to impose emergency curbs on short sales.

At one point, it cost a full 285 basis points (2.85%) more to insure Italian bonds than it does to cover German debt.

This implied decline in Italian credit quality is significant to global macro traders for a number of reasons.

Barely six weeks ago, the spread was considered somewhat elevated at 170 basis points (1.70%), but today’s move indicates that Italian bonds are now under more pressure than Spain was suffering late last year — back when it still looked like the wheels were coming off that country’s banking system.

And with the Milan exchange kicking in new rules that force short sellers to reveal any bets above 0.2% of a security’s net capitalization, the shorts are clearly pushing hard.

The European Union has been forced to hold an impromptu meeting this morning on the Italian situation before a formal summit to work out a new solution for Greece.

The mere linkage of these markets — and closely linked economies — in today’s financial headlines has opened new wounds for already-bleeding Italian banks and for the market in general.

Unicredit (UNCFF, quote) has shed another 8% of its value so far today and Intesa (ISNPY, quote) is down almost 10%:

Note of perspective: The broad-based Italian ETF EWI (quote) has plunged a breathtaking 23% since July 1.

This is a chart in free fall, but it also happens to represent the fourth-largest economy in Europe and the seventh-biggest economy in the world:

Spain is seeing plenty of pain, but these stocks have already gone through the wringer.

Santander (STD, quote) is down 6% and archrival BBVA (quote) is down 7%. And the Spanish ETF EWP (quote), which was back at $45 as recently as May 3, has retrenched 16% since: