European Crisis Live: Italy Downgrade Raises Contagion Concerns as ESM Debate Continues [VIDEO]

• Moody's cut Italy's debt rating two notches to Baa2
• Moody's warns Italy may be shut out of bond markets
• Italy's €3.5bn 3 year debt sale attracts lowest yield since May

1345 BST: Spain cancels summer bond auction

August is a particularly quiet time in European financial markets, so it's not a huge surprise that Spain has chosen to cancel a debt sale planned for 16th of that month (in-line with a similar decision by Italy earlier this week). Instead Spain will test the now slightly more optimistic debt market waters on Thursday 19 July with sales of 2 year, 5 year and 7 year paper. We'll know the amount they're looking to raise on Monday.

1255 BST: Circling the wagons

The European Commission hit back at Moody's Investors Service and its decision to lower Italy's credit rating two notches, to Baa2, despite the "determined and wide ranging policy actions the country has taken under Prime Minister Mario Monti.

"I do think one can legitimately and seriously question the timing of it, whether the timing was appropriate," said EC spokesman Simon O'Connor. "We consider that Italy's policy actions to ensure sound public finances address long-standing structural weaknesses and have been both determined and wide ranging.

1240 BST: Back at the tiller:

We've been chasing a fair bit of breaking news outside the Eurozone this morning, particularly here in Britain, where the Bank of England and the Treasury have revealed details of their "Funding for Lending" plan they hope will revive credit growth in the Moribund UK economy.

We've also had a look at the explosive emails between BoE Governor King and US Treasury Secretary Tim Geithner which suggest King was made aware of libor misdeeds at least four years ago.

And last but by no means least, my colleague Lianna Brinded is live-blogging JPMorgan's earnings and the ballooning "London Whale" loss that's cost the bank more than $4.4bn.

1015 BST: Italy bond auction results

Italy's new €3.5bn 3 year bond sale is a solid first dip into the markets after last night's downgrade: while still expensive at 4.65 percent it's still 85 basis points cheaper than a similar 3 year bond sale by Italy in June and the lowest nominal yield since May. Investors bid for around €6.1bn for the €3.5bn sold.

Just prior to the auction results, Italy's undersecretary for the Treasury, Gianfranco Polillo, said the Moody's decision was "entirely arbitrary" and not based on strong economic reasons. For the moment at least, he would seem to have a point.

1005 BST: Late inflation

Italy's EU harmonised consumer price index (HICP) was published an hour late this morning as part of a protest by the ISTAT, the national statistics office, to proposed changes in civil service working conditions in Prime Minister Mario Monti's reform package. The figures themselves were unsurprising: the cost of living in June rose by 0.2 percent from May and 3.6 percent from a year earlier.

1000 BST: Record borrowing:

Spain's banks borrowed a record €365bn from the European Central Bank last month, up from a then-record €325bn in May, according to Bank of Spain data published this morning. The figures both suggest the difficulty Spanish banks are having in getting access to the inter-bank lending markets and highlight the necessity of getting the ESM activated in order to allow it to fully support Spain's banking system with the €60bn to €100bn in capitalisation it may need to prevent collapse.

0915 BST: Barclays on Moody's downgrade

Overall, while we are not surprised by Moody's decision given its recent pronouncements on both Spain and Italy, we do find it somewhat perplexing for the following reasons:

1. While it is true that the rhetoric heated up in the past few weeks, political parties continue to support PM Monti's government and early elections look unlikely at this stage, in our view;
   
2. While contagion risks remain on the table, we think that the latest decisions undertaken at the European level and also by Spanish and Greek governments go, if anything, in the right direction of giving more stability to the euro area as a whole; and
   
3. While we agree that economic prospects have deteriorated, raising the risk of potential fiscal slippage compared to the target set for this year by the country (eg a budget deficit of 1.7% of GDP), we think that other points should also have been taken into account:

0840 BST: Italy debt auction preview

Tough sledding ahead for Italy's Tresor as it attempts to raise around €5bn and launch a new 3 year note issue (4.5 percent coupon, July 2015 maturity) at the same time. The June sale of 3 year paper raised around €3bn and cost Italian taxpayers 5.3 percent.

Italy will also tap existing debt tranches of 2019 and 2022 maturities for a maximum total of around €1.75bn.

Benchmark Italian BTPs are trading north of 6 percent (6.04) while BTP futures are slightly firmer after a weak opening and are changing hands at 98.58.

0825 BST: Moody's snippets

A few notes from the text of Moody's downgrade note on Italy:

• The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognized.
  
• Italy's near-term economic outlook has deteriorated, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets. Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding.
  
• Moody's is now expecting real GDP growth to contract by 2% in 2012, which will put further pressure on the country's ability to meet its fiscal targets, which were scaled back when the country published its Stability Programme in April. Although its goal of achieving a structural budget balance in 2013 has not changed, the government now expects to achieve a nominal balanced budget in 2015, two years later than it expected when adopting a package of fiscal adjustment measures in December 2011.

0805 BST: Equity gains

The bookies call it right - again - as the FTSE lifts by around 0.3 percent in the opening minutes of trading. Spain's IBEX, however, gives up around 0.2 percent and Italy's FTSE MIB sags by around 0.3 percent. In Germany, solid gains for the DAX of around 0.4 percent suggest investors will be looking at export-led markets to benefit from the assumption of China stimulus. France's CAC-40 is also up an early 0.4 percent.

0750 BST: Good Morning!

Italy's two-notch downgrade to the near-edge of junk status last night by Moody's Investors Service late Thursday provides investors with a stark reminder this morning of the need for European cohesion in solving the region's spiralling debt crisis. Moody's specifically warned that Italy's financial challenges could prevent them from accessing international capital markets in the near future - a hugely significant concern given the fact that Italy needs to borrow at least €112bn between now and the end of the year.

In fact, Italy has a €5.25bn bond auction scheduled for later this morning, in which it hopes to sell a near 3-year bond issue after yesterday's successful short-term debt sale that raised around €7bn.

The move also brings to the fore the dangers of any delay in ratifying the European Stability Mechanism, the permanent bailout fund that will be use, inter alia, to support Italian bond prices in the open market. Germany's Constitutional Court may take several weeks - or even longer - to hear and debate legal challenges to Germany's participation in the €700bn Fund, making full EU ratification impossible.

The Moody's downgraded clouded what would have otherwise been a solid Asia trading session after China posted a disappointing 7.6 percent growth figure for its second quarter GDP. The tally suggests policy makers in China will likely embark on a fresh round of stimulus to ignite growth and ensure a stable level of employment.

The MSCI Asia Pacific Index fell 1.16 percent to 114.68, its lowest level in around three weeks, following the Italian downgrade. European markets, however, are expected to open firmly, according to financial bookmakers, who expect gains of around 32 points at the bell for the FTSE 100 and similar gains for the DAX and the CAC-40 in Paris.

Those gains will be difficult to maintain if the early bond market reaction is any guide: German September bund futures are trading 10 ticks higher at a multi-week high of 144.94 while the benchmark 2 year Schatz is trading a negative 0.04 percent yield.

Italy's benchmark 2 year notes are 16 basis points higher at 3.97 percent while 10 year paper is marked at 6 percent. Spain's 10 year bonds are trading at 6.72 percent.