Spain and Italy paid a high price to sell short-term debt on Tuesday, compounding investors' concern that last week's bailout package for Greece left the euro zone's debt crisis unresolved.

Spain's short-term cost of borrowing hit three-year highs and demand fell at its Treasury bills auction while yields at a sale of six-month Italian paper hit their highest since November 2008.

The most important point again is the fact that relative to the last auction yields are much, much higher, said Marc Ostwald, a strategist at Monument Securities in London.

It shows we may have had some relief last week, but that relief has proven to be rather short-lived.

Spanish and Italian benchmark bond yields rose after the auctions and the premium demanded to hold Spanish debt rather than lower-risk German bonds widened, reflecting investors' doubts that European policymakers have resolved a crisis that has forced Greece, Ireland, and Portugal to seek international aid.

In another worrying sign, Deutsche Bank's second-quarter results on Tuesday showed that the German flagship lender has been slashing its exposure to peripheral euro zone countries including Spain and Italy.

Five days after a euro zone summit agreed a second Greek rescue, Spanish and Italian bond yields are back to the levels seen in the days before the deal was struck. German Bund futures prices, the benchmark of the euro zone debt market, are also back up at pre-summit levels.

BLEAKER REASSESSMENT

Last Thursday's agreement aimed to prevent a disorderly default by the debt-laden country and widened the scope of what their rescue fund can do to stop the crisis spreading.

Initial market enthusiasm for the deal saw the euro, peripheral euro zone bond prices, and shares rise.

But the relief rapidly faded as the focus turned to the difficulties in implementing aspects of the package and the fundamental problems of debt sustainability that have yet to be addressed.

The package was viewed quite positively ... Beyond that, it has run into problems over how to implement it. That has been a struggle, Commerzbank rate strategist David Schnautz said.

Top of analysts' concerns is that the euro zone's rescue fund, the European Financial Stability Facility, has not been given extra funds to draw upon despite being handed a much wider remit.

People are concerned that the overall size of the EFSF still hasn't been increased, said Eric Wand, interest rate strategist at Lloyds. I'd like to think the recent extremes would cap near-term movements but the situation is still very fragile.

There are also question marks about how many banks will sign up to the bond exchanges or buybacks agreed to ease Greece's debt burden.

Investment bank JPMorgan said some investors were unlikely to take up the offer to voluntarily swap Greek bonds that were maturing for longer-term paper and would instead sell whatever they had left on their books each time prices rebounded.

We believe that it will be difficult to achieve the required 90 percent participation rate since financial institutions will be tempted to sell Greek bond holdings into recent strength, JPMorgan said.

Procedures for a voluntary swap of privately held Greek government bonds for longer maturity paper will start in August, Greece's deputy finance minister said on Tuesday.

Most fundamentally, Greece faces a still mountainous debt to tackle while deep in recession, leading most economist to predict a more fundamental restructuring in future, with all the contagion risks that that prospect entails.

Spain and Italy have been under intense market scrutiny and fears that the crisis could spread to engulf these bigger and systemically more important euro zone states has seen their borrowing costs soar.

If either required bailing out the euro zone's resources would be stretched to breaking point.

A week ago, impatience over policymakers' handling of the crisis had driven 18-month Spanish yields to their highest in nearly a decade and the longer-term cost of borrowing was at its highest since the launch of the euro in 1999.

Italy's blue chip FTSE MIB has fallen 5.8 percent so far this month, the worst performer among peripheral and major European equity indexes. Spain's IBEX 35 is down 5.3 percent.

Italian bonds could come under further pressure as investors make room for sales of up to 10 billion euros worth of longer-term debt on Wednesday and Thursday.

(Writing by Nigel Stephenson; Additional reporting by Emelia Sithole-Matarise, Ana Nicolaci da Costa and Jeremy Gaunt; Editing by Swaha Pattanaik and Mike Peacock)

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