LONDON (REUTERS) - Borrowing costs for some of the euro zone's most highly indebted southern states shot higher on Thursday, as fears of slowing economic growth wounded confidence that the European Central Bank (ECB) could avert another debt crisis in the bloc.

Greek government bonds were the hardest hit as a sharp sell-off gripped financial markets for a second day, with 10-year yields rising briefly over 9 per cent, while Spain missed its target at a bond auction due to weak demand from investors.

With stocks volatile and oil prices plunging, investors sought refuge in safe-haven German bonds, pushing yields on the euro zone benchmark to record lows before strong US data and comments from a Federal Reserve policymaker brought some relief.

ECB president Mario Draghi helped to calm the last euro zone crisis by promising two years ago to do whatever it takes to save the euro.

This brought down borrowing costs of "peripheral" euro zone countries such as Greece, which had been bailed out by the European Union and IMF, and Spain, which took EU aid to rescue its banks.

Interest rate strategists said investors could increasingly start to question whether the ECB would resort to its ultimate policy weapon for averting a crisis - buying government bonds.

"It's early days... but if the market loses faith in what monetary policy can do to fend off falling global growth and the risk of deflation, then it could become a much more serious issue," KBC rate strategist Mathias van der Jeugt said.

In the biggest two-day sell off since July 2012, Greek 10-year yields shot up more than 100 basis points (bps) to over 9 per cent before easing back to 8.96 per cent. While this is well short of the 40 per cent peak they reached in 2012, past rises in European peripheral bond yields have picked up pace above 7 per cent.

Greece aims to ditch its unpopular bailout programme with the EU and International Monetary Fund, which demanded severe austerity, and return to relying on markets to raise funds, a plan that has worried investors.

Policymakers tried to reassure the markets, with the ECB saying it would loosen the rules on collateral to give Greek commercial banks access to more funding.

Greek Finance Minister Gikas Hardouvelis said the turmoil did not reflect the fundamental state of his country's economy.

"Those monitoring markets know that very often they are nervous, excessive in their reactions," he told parliament.

Compared with Germany, the premium or "spread" that Greece pays to borrow over 10-years was the highest in more than a year. Italy's and Portugal's were at two-month highs and Spain's at a six-week high.

Italian 10-year yields rose 15 bps to 2.54 per cent, Portuguese yields were up 21 basis points at 3.51 per cent while Spain's were up 10 bps at 2.19 per cent.

By contrast German Bund yields hit a new low of just 0.716 per cent, before rising again to 0.82 per cent.

Strong US employment and industrial output data and comments from the head of the St Louis Federal Reserve that the central bank may want to keep buying bonds helped to steady markets.

In Thursday's auction Spain sold only €3.2 billion (S$5.2 billion) of debt due to weak demand, falling short of the top end of its target amount.

"(This is) the first time I can remember this happening in quite some time... This weakness is unsurprising given the very chunky increase seen in all euro zone spreads versus the Bund this morning," said Lyn Graham-Taylor, a strategist at Rabobank.

French five-year bonds sold at a new record low yield at an auction as investors took shelter in liquid, high-rated debt, but in secondary markets its yields were up 6 bps at 1.2 per cent.

Market jitters were made worse by a rift in Brussels as France and Italy present 2015 budgets that appear to break EU targets.

German Chancellor Angela Merkel told parliament on Thursday that Europe must cut public deficits and improve competitiveness because the euro zone debt crisis had not yet been overcome and its causes had not been eliminated.

There is also a debate in Europe's top court over whether the ECB's promise to buy euro zone government bonds if this were needed to save the euro would breach of its mandate and amount to direct monetary financing of governments.

If the challenges made by German lawmakers are upheld, it would probably torpedo an ECB programme to buy government bonds that investors are depending on.

"The ECB only has one card left to play and it doesn't look imminent," said one government bonds trader.