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The market's lack of confidence in the Italian government is pushing the country to the edge. Rising funding costs threaten to shutdown the country's access to the bond market, a scenario for which neither Italy nor the Euro-zone is ready. Given the country's enormous funding needs relative to the size of the Euro-zone rescue fund, this turn of events poses a serious challenge to the two-week-old European plan to come to grips with the long-festering sovereign debt crisis.

Italian government bond yields had been trending up in recent days. The announcement Tuesday that prime minister Silvio Berlusconi will relinquish power had raised hopes of a reversal in that trend. The positive momentum in the market on Tuesday was largely a reflection of that view. The trigger for today's yield spike was the decision by a major clearing firm to raise margin requirements for Italian government bonds.

With the yield on the 10-year Italian government bond reaching a new Euro-era record of above 7%, more than 500 basis points above comparable German government bonds, it will not be long before questions get raised about the country's liquidity position. Ireland and Portugal had to ask for bailout when their bond yields reached this level. But Italy is way too big for that kind of treatment. Its debt, roughly 120% of its GDP, accounts for almost one quarter of all Euro-zone debt. And with about €300 billion in bonds coming due next year, the country's funding needs dwarf the ability of the Euro-zone rescue fund to come to its aid.

The best short-term solution would have been if the European Central Bank (ECB) could play the lender of last resort role that the Federal Reserve plays in the U.S. The ECB has been making some bond purchases, but they are fairly modest relative to the size of the Italian bond market, the third largest in the world. The ECB believes that its founding documents precludes it from back-stopping member-country borrowing.

On the earnings front, we have a positive earnings and revenue surprise from General Motors (NYSE:GM) this morning. The company lowered the outlook for its European operations, indicating that it will not be able to meet its original target of breaking even in Europe this year. Blue Nile (NASDAQ:NILE), the online jeweler, missed expectations on higher expenses and lower margins. We have Cisco (NASDAQ:CSCO) reporting after the close today.

But it's all about Italy today, with stocks likely giving back what they gained yesterday. We will have wait and see how the Italian situation unfolds in the coming days, but it doesn't look good.

Source: Mama Mia! The Italian Debt Crisis Continues Unabated