Spanish Bond; a licence to kill?

April 19, 2012

Back to the familiar grist of a Spanish bond auction today. This one has real power to move global markets as it offers up a 10-year bond for only the second time this year. Because of the ECB’s three-year money glut and the general point that uncertainty rises the longer you stretch the timeframe, shorter-term paper has been a much easier sell.

10-year yields broke above the portentous 6 percent level for the first time since late November earlier this week though they have since ducked back down.

Madrid is looking to sell up to 2.5 billion euros of 2- and 10-year bonds – a relatively small amount which should attract the requisite demand. But yields will climb. The last 10-year auction went at 5.4 percent. On the secondary market those yields are now around 5.8.

Given markets are positioned for a solid sale, there is clear downside risk if it doesn’t happen.

One potential problem is that the big buyers of Spanish and Italian bonds have been domestic banks, which are not in the rudest of health and would be even more exposed if sovereign yields head yet higher. The IMF said yesterday it expected Italian banks to buy 223 billion euros in domestic government bonds this year, with Spanish banks buying 135 billion. The IMF also warned that Europe’s deleveraging banks will shrink their assets by $2.6 trillion over the next two years, further starving the real economy of credit.

France will sell up to 8 billion euros of debt, including new 2-year bonds and up to 3 billion euros of inflation-linked paper. The auctions are expected to go smoothly, with markets apparently sanguine about the first round of presidential elections on Sunday. The second round, which polls suggest will anoint socialist Francois Hollande, who is intent on tinkering with some of the EU’s crisis policies, could be a different matter.

Focus starts to switch to Washington where G20 policymakers are starting to gather ahead of the IMF spring meeting. A deal on finding $400 billion plus of new crisis-fighting funds for the IMF appears to be coming together. As of last night, the Fund said it had got $320 billion in commitments so far. Add that to the new $500 billion euro zone rescue fund and it’s possible that market sentiment will start to shift. But, as the United States and Canada are pointing out, a firewall, no matter how big, does not solve the root problems of the crisis.

Washington is also urging Europe not to cut too hard, too fast for fear that recessions will be deepened, throwing recovery from crisis off course. Germany does not buy into that argument and turns a deaf ear to a call for the world’s strongest economies to buy a little more to help reduce global imbalances.

The markets may be coming round to that view if their muted reaction to Italy’s decision on Wednesday to slightly relax its budget deficit targets is anything to go by. Rome’s fiscal loosening was nothing like the magnitude of Spain’s – the point at which Spanish premier Mariano Rajoy rejected a previously agreed 2012 deficit target is pretty much when the bond market turned on Madrid – and Italy does not have the acute property market and banking problems that Spain has. But it wouldn’t have been hard to imagine a kneejerk sell-off on headlines that Rome was aiming for a higher deficit. It didn’t happen.

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