OREANDA-NEWS. February 18, 2015. Greek financial markets slipped but kept their composure on Tuesday after debt talks with the euro zone broke down, on expectations that Athens and its European partners would eventually agree a compromise.

Greek government bond yields rose as much as 110 basis points and stocks fell 2.5 percent, which were limited moves by the standards of Greece's illiquid markets. Both remained well off the extremes touched last week.

The reaction to Greece's rejection to a proposal to extend its bailout by six months pointed to higher levels of investor concern about the country's future in the currency union, but no panic.

The euro zone crisis, which started in Greece in 2010, has seen a series of who-blinks-first negotiations and policymakers have a good record of finding a way out of knife-edge situations.

"For now, we assume that logic will prevail and this movie won't end in disaster," said Paul O'Connor, multi-asset desk co-head at Henderson Global Investors.

"The politicisation of the debate, the wide gap between the two sides, and the fact that the stakes are so high meant that negotiations were inevitably conducted against a backdrop of hostility, threats, and brinkmanship. Welcome to the euro zone!"

The talks on Monday broke down in less than four hours, far sooner than expected. On Tuesday, both parties said they were open to a resumption of talks.

Jeroen Dijsselbloem, the Dutchman who heads the euro zone finance ministers' group, said Greece had until Friday to request an extension of its bailout. He said he was ready to work with Athens towards a deal.

Greek Prime Minister Alexis Tsipras said his government could not succumb to blackmail from its euro zone partners and was in no hurry to reach a new debt agreement.

Greek 10-year bond yields rose 71 basis points to 10.63 percent and three-year bond yields were up 110 bps at 18.75 percent. Ten-year yields approached 12 percent last week and three-year yields topped 22 percent -- levels not seen since Greece's default in 2012.

Nerves were strung tight, nevertheless.

"Having shortlisted Greek government bonds as one of our 15 top trades for 2015, we admit that it is proving a rather uncomfortable wait," Morgan Stanley analysts said in a note.

For a factbox of holders of new Greek debt see .

CONTAGION

Spillover into other markets was limited. Italian and Spanish borrowing costs remained within half a percentage point of record lows, with buyers of peripheral debt focusing on the prospect of about 1 trillion euros of European Central Bank bond purchases.

But a Greek exit from the euro zone, or Grexit, is likely to lead to contagion, analysts said.

If that were to occur, investors would naturally sell bonds of the euro zone's next weakest link, which is Portugal. But because of the rise of Spain's Podemos party, whose agenda bears similarities to the new Greek government's, Madrid markets may become a target as well, said Vincent Chaigneau, Societe Generale's head of fixed income and forex strategy.

A way to hedge against Grexit was to bet on a widening of the gap between forward euro zone overnight Eonia rates and benchmark bank-to-bank Euribor rates, a key indicator of stress in the banking sector, he said.

Athens' main ATG share index fell 2.45 percent to around 838.6 points, well above a trough of 708.61 touched after the leftist Syriza party won last month's Greek election. An index of Greek banking stocks dropped 6.4 percent.

The ECB will decide on Wednesday whether to maintain emergency lending (ELA) to Greek banks that are bleeding deposits at an estimated 2 billion euros a week. If that pace were maintained, the lenders would run out of collateral for funds within 14 weeks, according to JPMorgan.

"It is unthinkable that the ELA will be pulled as long as there are still discussions taking place," said Mark Dowding, a senior portfolio manager at BlueBay. "Pulling the ELA would almost be akin to putting a bullet in the head. It is accelerating a move towards Greek exit, and that is something that the ECB will be very reluctant to do."

The cost of insuring Greek debt against default, as reflected by five-year credit default swaps, rose to 1,813 basis points from 1,526 bps, according to data from Markit. That implied investors saw a default probability of about 80 percent.

"A failure to reach an agreement in the coming weeks could easily trigger bank runs, ECB liquidity withdrawal, and even a Grexit," said Jan von Gerich, chief fixed income analyst at Nordea. "The stakes are thus high."