A weekend wipe-out of Spain's ruling Socialists in regional and municipal elections raised fears of potential clashes over deficit curbs between central and local government as Madrid fights to avoid having to seek a bailout like Greece, Ireland and Portugal.

Italy, which has the euro zone's biggest debt pile in absolute terms, was hit by credit ratings agency Standard & Poor's decision on Saturday to cut its outlook to "negative" from "stable."

Government sources said Rome would bring forward to next month planned decrees to slice 35 to 40 billion euros off the budget deficit in 2013 and 2014, in an effort to reassure markets.

"We've kept things in order and the bases are all there for us to continue to do so," Economy Minister Giulio Tremonti said.

The premiums charged by investors to hold Italian and Spanish 10-year bonds rather than safe-haven German bunds rose to their highest levels since January, at 186 and 261 basis points respectively.

The euro briefly fell below a key support level at $1.40, hitting a two-month low against the dollar, before stabilizing.

"The key point is that the crisis seems to be taking hold even of peripheral countries regarded as solid," said WestLB rate strategist Michael Leister.

"Sentiment is that there appears to be no end to it now Italy is being scrutinized by the ratings agencies."

NO SURRENDER

Stratospheric Greek debt yields rose still further — with 10-year bonds yielding more than 17 percent — amid uncertainty over a crucial 12 billion euro aid disbursement next month which is vital to meet 13.4 billion euros in funding needs, including debt redemptions, in mid-June and avoid default.

The Greek yields do not reflect Athens' real borrowing costs because the country is surviving on IMF/EU loans and trading in Greek bonds is thin, but it is a barometer of market anxiety about some form of debt restructuring.

The Greek cabinet met to discuss new emergency deficit cutting measures to try to persuade international lenders to keep aid funds flowing, and convince investors the country can cope without a restructuring.

"We are in the middle of an ongoing battle. We will not surrender. We will do whatever it takes to make sure Greece stands on its own feet," Prime Minister George Papandreou told voters last week, preparing them for still harsher austerity.

Visiting inspectors from the European Commission, the European Central Bank and the International Monetary Fund are withholding judgment on Greece's compliance with its rescue program until they see progress on spending cuts, revenue increases and stalled privatisations.

Among planned new belt-tightening measures were deeper cuts in public sector wages, more consumer tax increases and even the taboo issue of dismissing full-time civil servants.

The chairman of the 17-nation Eurogroup of finance ministers of countries sharing the single currency, Jean-Claude Juncker, said on Saturday that Greece has fallen behind targets and should set up a trustee institution for privatisations.

Market sentiment has darkened due to public disputes among the IMF, the ECB and Juncker over whether some form of debt "reprofiling" or "soft restructuring" should be brought into the policy mix.

"CREDIT EVENT"?

The European Commission's top economic official, Olli Rehn, sought to play down talk by Juncker of a "soft restructuring" that scared markets after last week's Eurogroup meeting. Rehn said any relief from bondholders would be on a voluntary basis.

"A voluntary extension of loan maturities, so-called reprofiling or rescheduling on a voluntary basis, would also be examined on the condition that it would not create a credit event," Rehn told reporters.

Market experts say any attempt to modify debt maturities while avoiding a so-called credit event that would trigger default insurance payouts and downgrades by ratings agencies would be likely to face legal challenge.

Severe austerity measures imposed under the IMF/EU bailouts or to avert a bailout are taking a high political toll on governments across Europe.

Spain's ruling Socialists suffered their worst election result since the restoration of democracy in 1978, slumping to 27 percent of the vote, 10 percentage points behind the conservative opposition Popular Party.

Italy's centre-right government lost ground in local elections last week, and a weekend opinion poll in Greece showed that for the first time since Socialist Prime Minister George Papandreou took office in 2009, the centre-right opposition New Democracy party has drawn level with the ruling Socialist party.

The unpopularity of rescuing euro zone debtors was reflected in another disastrous regional poll result for German Chancellor Angela Merkel's centre-right coalition on Sunday.

Her Christian Democrats slumped to just 20 percent in Bremen, Germany's smallest federal state, while the liberal Free Democrats, junior partners in government, scored just 2.6 percent and lost their seats in the local assembly.