Spain’s house of cards

October 26, 2012

Looking at some of the recent trends in the euro zone debt market, one could be forgiven for thinking the region is doing alright.

Spanish and Italian funding costs have come down sharply. Data from the European Central Bank on Thursday showed consumers and firms put money back into Spanish and Greek banks in September. And there are budding signs that foreign investors are venturing back to the Spanish sovereign debt market. As one trader this week put it, the market is “healing”:

Liquidity is coming back, liquidity meaning the market can digest larger customer repositioning and flows again.

But data showing one in four Spanish workers were without a job in the third quarter of this year served a sour dose of reality.

Indeed, the stabilization in euro zone debt markets has mainly been fueled by promises of ECB support, should Spain decide to ask for aid.

The record high unemployment highlights the extent to which the recent improvement in Spanish debt markets is based on expectations rather than fundamentals and reality –  that Spain is in the grip of a recession that has undermined its efforts to stabilise public finances.

Elwin de Groot, senior market economist at Rabobank says:

That we’ve seen a little bit of improvement is really built on the assumption, on the expectation that there will be an aid request, that the ECB will start buying bonds and the ESM (euro zone rescue fund) will start buying bonds in the primary market.

But it’s all in the assumption that it will happen and if there is a risk that it won’t happen, then you could easily see the vicious circle return in the market and that’s the risk.

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