By William James and Marius Zaharia
LONDON (Reuters) - Spanish bond yields hit a new euro-era high above 7 percent on Monday as initial relief after a pro-bailout vote in Greek elections gave way to pessimism about the problems surrounding the bigger Spanish economy.
The swift reversal in sentiment, fueled also by data showing Spanish banks' bad loans rose to their highest since April 1994, bolstered German Bund futures, quickly erasing more than a full point of early losses, while European equities and the euro wiped out early gains.
Political parties in favor of Greece's bailout lifeline began talks to forge a government on Monday after a narrow victory over radical leftists who wanted to tear up the existing aid agreement.
That removed the risk of an imminent Greek exit from the currency bloc, but the slim margin left major doubts over how effectively a pro-bailout coalition could govern, with markets taking the view that Greece may still end up leaving the euro.
"The Greek vote had the best outcome that one could have thought about," UBS rate strategist Gianluca Ziglio said. "But there's still going to be a lot of uncertainty and Spain is reaching levels in spreads ... which are scary."
Spanish 10-year bond yields were 26 basis points higher at 7.18 percent, leaving the spread over benchmark German Bunds at 577 basis points. They hit 7.30 percent earlier in the session, the highest level in the euro zone's history.
In a sign of growing fears over the sustainability of Spain's finances, short-term debt underperformed, with two-year yields rising 45 basis points to 5.54 percent.
The spiraling borrowing costs are threatening Madrid's ability to fund itself and raising speculation that Spain may need a full-blown bailout. Greece, Ireland and Portugal were forced to seek international bailouts soon after their 10-year bond yields rose above 7 percent.
"The bigger problem is 'How do you deal with Spain?' and there doesn't seem to be a satisfactory solution there," said Elisabeth Afseth, strategist at Investec in London.
An audit later this week is expected to show Spanish banks needing between 60 and 70 billion euros ($75-88 billion) in capital. UBS's Ziglio said markets would have more confidence in the effectiveness of the capital injection if it was worth closer to 100 billion euros.
Spain said on Monday it plans to sell 2-3 billion euros in 12- and 18-month Treasury bills on Tuesday and 1-2 billion euros of bonds maturing in 2014, 2015 and 2017.
The short maturities on offer were illustrative of Spain's discomfort in funding markets.
Dwindling international investor demand has forced Spain to issue small amounts of shorter-term bonds, which are cheaper to issue and attractive to domestic banks but shorten the country's debt profile, creating large redemption humps down the road.
Nevertheless, domestic banks were expected to make sure that the auction attracts enough demand to go smoothly.
"It seems to me as if the primary dealers and domestic banks and money managers all recognize that if they don't turn up to the auctions the game is over," said a head of trading at one primary dealer. "Consequently we continue to maintain access to capital markets for the periphery."
The cost of insuring against a Spanish default hit a record high of 612 basis points according to data monitor Markit.
German Bund futures, which rise when investors are looking for safer instruments to park their cash, were last 25 ticks higher at 142.54.
They came off highs of 143.09 after Fitch Ratings said it saw a lower risk of a disorderly Greek debt default and exit from the euro area, but traders warned volumes were low and the move could quickly reverse.
(Editing by Ruth Pitchford)