(Adds details, updates prices)
By Stefano Rebaudo
June 13 (Reuters) - Italy's 10-year bond yields rose above 4% for the first time since 2014, the cost of insuring exposure to its debt rose to the highest since 2020 and bank stocks slid on Monday pressured by the prospect of sharp rate hikes and waning ECB support.
Investors also pushed up the premium they demand to hold the bonds of southern European states over safer Germany just days after the European Central Bank flagged rate hikes to contain high inflation, but said it saw no need to create a new tool to help weaker economies cope with rising borrowing costs.
Exacerbating the unease was a view that Friday's stubbornly hot U.S. inflation reading could prompt the Federal Reserve to deliver a jumbo-sized interest rate rise this week.
Italy's 10-year bond yield rose to as high as 4.097%, the highest level since January 2014 and was last up 25 basis points on the day. That pushed the Italian/German 10-year bond yield gap - a gauge of euro area financial stability - to its widest since May 2020. It was last at 246 bps.
Spanish and Portuguese bond spreads over German debt were also at their widest since 2020 , and five-year credit default swaps for Italy and Portugal rose to their highest levels since 2020.
"Spreads are widening not because Italy has a funding problem but because the market wants to see how serious the ECB is about keeping spreads under control," said Andrew Mulliner, Head of Global Aggregate Strategies at Janus Henderson.
Fragmentation risks, namely the divergence in financial conditions across the euro area, battered Italian banks - big holders of domestic debt.
Italy's banking index was down 3.8%, having lost a quarter of its value since the start of the year. Shares in Italy's biggest banks Intesa Sanpaolo and UniCredit's fell 4.2% and 1.8% respectively.
UBS estimates that a 100 bps spread widening leads to a moderately negative but manageable 30-40 bps point capital erosion.
As expectations of even bigger U.S. rate hikes gripped markets, investors ramped up bets on ECB tightening. Markets now price in around 167 basis points by year-end – indicating a chance of at least two 50 half-point rate hikes - compared with 135 basis points before Thursday's ECB meeting. They fully price 75 bps by September.
Germany's 10-year bond yield was last at 1.634%, its highest since April 2014, up 13 bps on the day.
The 2-year yield rose above 1% for the first time since August 2011, and was last up 12.5 bps at 1.152%.
A selloff also rocked U.S. bonds leading to their yield curve inverting, with two-year yields exceeding 10-year ones, in a sign of recession risks.
"I don’t think the (euro area) bond selloff, at least at the front end of the curve, is over as long as inflation remains the main focus of the central bank," said Wolfgang Bauer, fund manager at M&G Investments.
"But at some point, the pressure on economic growth will become the main topic for central banks and will affect their monetary policy decisions," he added.
Investors will also watch those central banks which have recently been dovish despite surging inflation, with the Swiss and Japanese central banks meeting later this week.
"Expectations are that they won't change their policy, but if they do, we will see a significant impact on the market in terms of further yield rise," said Janus Henderson's Mulliner.
"The SNB and the BoJ have not hiked rates for ages; they represent the global yield anchor," he added.
The Bank of England is also expected to hike rates on Thursday.
(Reporting by Stefano Rebaudo, additional reporting by Danilo Masoni; editing by Dhara Ranasinghe and Tomasz Janowski) ;))