Italy's financial markets calmed Thursday on the prospect of a new government led by the country's respected economist Mario Monti.

Mario Monti [File photo]

Milan stocks first saw a decline by more than one percent but swung back to green and gained 1.5 percent in morning trading.

In a treasury auction earlier on Thursday, Rome also managed to raise five billion euros, though at the cost of a record high interest rate of 6.087 percent.

The 10-year bond yields dropped to 6.98 percent, just below the critical 7-percent threshold, with its spread against the German benchmark bond falling from 574 basis points to 520.

The 10-year bond yield reached over 7 percent on Wednesday, after Prime Minister Silvio Berlusconi's announcement that he would step down, but only after the Parliament approves an austerity package.

The jittery markets calmed on Thursday when Mario Monti emerged as a possible leader of a new government.

Foreign Minister Franco Frattini said he supported an emergency government of national unity led by the former European commissioner.

"He (Monti) has an international profile that no-one can deny," Frattini said, noting he had worked "very hard" during his term in Brussels.

Italian President Giorgio Napolitano appointed Monti, a highly-respected and unaligned economist, a life senator later on Wednesday.

Wednesday, the day after Berlusconi tendered what Italian newspapers called a "conditional resignation," was a dark day for the economy in Italy -- and in Europe as a whole.

The Italian Stock Exchange in Milan erased two days of gains by mid-morning and finished the day down nearly 4 percent, sparking similar sell-offs across Europe's main exchanges.

The euro lost almost 3 cents against the dollar, it's largest one-day drop in two months.

Most importantly, the yield on Italy's 10-year benchmark bond shot above the 7-percent barrier Wednesday to close at 7.25 percent, by far its highest close since the inception of the euro in 1999.

Greece, Portugal and Ireland were all forced to seek international bailout after their borrowing costs reached similar levels.

Economists say that if Italy is forced to pay more than 7 percent interest in order to refinance its debt, the costs would be unsustainable.

Antonio Bolzano, an economist with ABS Securities, said the rising debt yield and other factors were as much a reflection of political uncertainty than of underlying shifts in the country's economic health.

"From the market's perspective, it would probably be better if Berlusconi left than if he stayed, but the worst-case scenario is that neither happens and the country is caught in some kind of in-between state," Bolzano said. "That's what happened Wednesday -- the market reacted strongly because it did not know what to expect."

So far, the debate on the austerity measures Berlusconi had made conditional to his resignation has been slow to move forward.

The Italian press on Wednesday speculated that the approval of the measures could drag on for weeks at a time when its implementation is badly needed.

"The austerity plan is probably too small to save Italy, but it is clearly better to have it in force," Bolzano said.

In an unexpected development, pollsters reported that preliminary results are showing that Berlusconi's approval levels, though still low, are actually on the rise since he said he would step down.

"People in Italy have always liked the idea that Berlusconi beats the system and perhaps they think he will do it now one more time," said Maria Rossi, Opinioni's co-director, adding that the final results of the in-progress poll will be available Monday, the day a new government of the country is expected to be formed.