The relief in Rome was short-lived. Italian bonds rallied early on June 11, the first trading day after European finance ministers’ weekend agreement on a $125 billion bailout for Spanish banks.

But within hours, Italian borrowing costs were creeping back up again, reflecting persistent market fears that the Continent’s third-largest economy could be the next to falter. “Contagion into Italy and other countries is a reality,” Joachim Fels, chief global economist at Morgan Staley in London, said in a Bloomberg Television interview as the bond rally petered out.

There seems to be little Italy can do to innoculate itself. Prime Minister Mario Monti, appointed last November to succeed Silvio Berlusconi, has moved decisively to get government finances in order, overhaul the pension system, and implement regulatory reforms. The country is on track to bring its budget deficit within 3 percent of GDP this year. Italian banks are relatively healthy, and unemployment is less than half the 24 percent in Spain. “Spain’s fundamentals are a lot direr than Italy’s,” says Nicholas Spiro, managing director at Spiro Sovereign Strategy in London.

Italy’s situation is hardly rosy. Its debt burden—120 percent of GDP—is the highest of any European country except Greece. Its economy slid into recession during the fourth quarter of 2011 and is expected to contract 1.7 percent this year. “Monti’s reform agenda is stalling, unemployment at 10.2 percent is the highest in a decade, and consumer confidence is the lowest in 15 years,” Marc Chandler, a currency strategy at Brown Brothers Harriman, wrote in a June 11 research note. “Italy is positioned to be the next lightning rod in the euro area.”

For now, yields on Italian debt are at 5.84 percent, less than they were when Monti took over last year and well below the maximum 8 percent that officials have said the country can afford.

Maria Cannata, the head of Italy’s debt agency, said last week that fewer foreign investors had been participating in debt auctions in recent months. That means the Italian Treasury is more dependent on local banks, which have been among the heaviest borrowers from the European Central Bank in the past three years. “If Italy has a problem with accessing the markets because investors lose confidence in the Italian ability to do the right thing, the ECB will be drawn into the fire,” says Thomas Mayer, an economic adviser to Deutsche Bank.

Although the focus is now on Italy, it could soon shift to France. President François Hollande campaigned on an anti-austerity platform, and his Socialist Party and its allies took 46.9 percent of the popular vote in the first round of parliamentary voting on June 10. But Hollande won’t know until the June 17 second round if he’ll have an absolute majority. If he doesn’t, he’ll have to form a coalition with far-left parties, some of which are demanding big increases in government spending that would undercut Hollande’s promise to reduce France’s budget deficit.

Investors will be watching closely, Chandler says. “Hollande’s honeymoon may last through the final round of the parliament elections. But then things will become more difficult.”

—Based on reporting from Andrew Davis, Chiarra Vasarri, and Nadine Skoczylas

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