MacroScope

In euro zone terms, two themes will dominate the week: Spain and the size of the euro zone rescue fund (Italy’s labour reforms will play a supporting role).

Yesterday, Spanish Prime Minister Mariano Rajoy won a key regional election in Andalusia although not as handsomely as hoped, raising the possibility that the socialists could rule there if they find a coalition partner. The result could hamper the government’s plan to press the autonomous regions harder to cut public spending. Having ripped up the deficit target agreed with Brussels last month, Spanish borrowing costs are already on the rise. Any further sign of wobbling could be seized upon by the markets. Spain faces a general strike on Thursday and Rajoy’s administration will present its full 2012 budget on Friday.

Also at the back end of the week, EU finance ministers meet in Copenhagen with the thorny issue of how, and by how much, to increase the euro zone’s future ESM rescue fund top of the agenda, which comes into being at mid-year.

Der Spiegel reported that Germany is ready to drop its resistance to a higher bailout fund and will consent to combining the resources of the current EFSF and the ESM for a limited period. One of the major headaches for Chancellor Angela Merkel is that she could have to seek ratification from the Bundestag. Many German MPs are firmly against putting any more resources into a pot to bail out weaker partners. But there are suggestions that by combining the two funds temporarily, the German parliament may not need to have a say.

Merkel’s surprise weekend victory in a regional election in Saarland may embolden her somewhat, although her FDP coalition allies were all but wiped out.

Morning all from a fogbound London. Visibility may be down to a minimum but there is a developing view that the euro zone debt crisis, if not solved, is in remission.

Spain should follow Italy’s lead yesterday and sell short- to medium-term bonds with ease despite a tussle with the EU over what deficit level it should be aiming for next year. Madrid will sell up to 3.5 billion euros of three- and four-year paper, a lower amount than it has been pushing out so far this year, which means it should be snapped up.

There has been some disquiet in the market after Prime Minister Mariano Rajoy threw out a Brussels-agreed target of a 4.4 percent/GDP deficit this year and said he would only shoot for 5.8. His peers have subsequently hauled him back to 5.3. But any doubts over debt slippage continue to be overwhelmed by the wall of money created by the ECB which is sloshing around the financial system looking for a home.

Top billing of the day probably goes to Germany’s Merkel and Italy’s Monti meeting in Rome, though it is quite late in the day.  The Italian premier remains the austerity poster boy, in contrast to Spain’s Rajoy who was partially let off the hook by Brussels last night for abandoning his deficit target, though he was told to split the difference between the first target and his new, looser goal.

While trying to avoid a blizzard of numbers, Spain was supposed to land a deficit of 6 percent of GDP last year and 4.4 this, en route to the main target of 3.0 percent in 2013. Rajoy’s new government announced that last year the deficit had in fact swelled to 8.5 percent of GDP and as such he would only aim for 5.8 percent this year while sticking to next year’s goal. The Eurogroup told him last night to aim for 5.3 this year, cutting some significant slack but, but by demanding more cuts than Rajoy wanted to deliver, probably avoiding serious market disquiet about Spain becoming the new Greece – forever missing its targets – and undermining the bloc’s new fiscal pact while the ink is barely dry.

Nonetheless, the net result is likely to be to drag Spain deeper into recession this year. Looking at bond yield spreads, the markets don’t smell blood yet.