The euro hit a 10-year low against the yen and an 11-month low against the dollar yesterday, ahead of a key auction of Italian government debt today.

Figures from the European Central Bank which showed a surge in the bank’s balance sheet also spooked markets.

Markets initially rallied yesterday after Italy’s borrowing costs plunged at an auction of six-month notes.

Italy raised €9 billion at a rate of 3.251 per cent – half the 6.504 per cent rate it was forced to pay in November when Italian bond yields first reached unsustainable levels. Some analysts suggested that European banks were using the recently issued European Central Bank money to fund the purchases.

While the outcome provided a temporary boost to European stocks and the euro, caution returned later in the session, pushing Italian bond yields higher and the euro to a new record low ahead of today’s auction of longer-dated Italian bonds.

Concern yesterday centred around signs that European banks are reluctant to lend to each other and are parking money with the ECB rather than using it to spur lending, after it emerged that euro-zone banks deposited a record amount of money with the European Central Bank this week.

The ECB last week provided a record €489 billion in loans to 523 banks to encourage lending to companies and households and prevent a credit shortage. Yesterday, the ECB confirmed that its balance sheet had soared to a record level following the unprecedented liquidity provisions.

Lending to euro-area banks jumped €214 billion to €879 billion in the week ending December 23rd, the Frankfurt-based bank said yesterday. Its balance sheet increased €239 billion to €2.73 trillion.

Italy is scheduled to sell up to €8.5 billion worth of debt with maturities in a scheduled auction today. Bonds due in 2014, 2018, 2021 and 2022 are scheduled to be sold. The nation’s 10-year bond yields climbed to 7 per cent yesterday, the level that foreshadowed bailouts for Greece, Ireland and Portugal.

In total, Italy expects to raise almost €450 billion from debt sales in 2012, enough to cover €202 billion of maturing bonds and finance a €23.6 billion deficit, according to the country’s director of public debt.

In the first full day of trading for some European stock markets since Christmas, trading was choppy yesterday, with European stock markets ending the session in the red, despite an early rally on the back of the Italian debt auction, after Wall Street opened lower.

The FTSEurofirst 300 index, which had risen 3.5 per cent in the week to Christmas, closed 0.7 per cent lower yesterday at 983.32. However, this was on low volumes, with the index trading less than 40 per cent of its 90-day volume.

The euro weakened against all 16 of its major peers except for the British pound and Danish krone.

The single currency lost as much as 1.1 per cent to 100.73 yen and decreased 1 per cent to an 11-month low of $1.2941. - (Additional Reporting: Reuters)