Spanish 10-year bond yields are within a whisker of breaking above six percent for the first time since December and are dragging Italy’s up with them. The balmy days of first quarter calm are well and truly over. “Markets step up the attack”, El Pais blares from its front page this morning.

Spanish risk premiums have leapt since Prime Minister Mariano Rajoy defied Europe by unilaterally easing Madrid’s 2012 deficit target and investors seem to have lost faith again as the impact of the ECB’s massive liquidity injection begins to fade.

BUT, and there is a but, there are good reasons to believe Spain will not fall over in the way Greece and others have. One silver lining for Madrid is that it has taken advantage of the benign market conditions early in the year to clear almost half its 2012 debt issuance needs so rising secondary market yields may be less damaging than they were last year.
As usual, confidence is key. The ECB three-year money has not vanished. Look at the 800 billion or so euros deposited back at the ECB by banks every day and it’s clear that if sentiment improved some of that money could be put to use once again to buy Spanish and Italian bonds, though there’s no sign of that for now.
Markets are resolutely “risk off” although weak U.S. jobs data last week have a part to play here. European stock futures are flagging a further 0.5 percent loss following a 2.5 percent tumble on Tuesday. The most reliable euro zone barometer – the Bund future – has edged lower at the open, probably in anticipation of Germany auctioning a new 10-year bond later. Given the climate, it should be snapped up despite yields already at record lows: While Spain faces a 6 percent price to borrow for 10 years, Germany can do so for 1.6 percent.

Perhaps the biggest problem for Spain is the state of its banks, ravaged by a property market collapse. The central bank admitted yesterday they probably needed more capital. There is little prospect of them raising it on their own and the government has ruled out more state aid but there is a distinct possibility that the EU’s bailout funds could do the job at some point this year. The numbers should be manageable and shoring up the banks would not completely invalidate Madrid’s insistence that it will not require a sovereign bailout.

Furthermore,  Rajoy is pushing through sweeping labour reforms and savage spending cuts. The trouble is that policy mix is likely to drive Spain further into recession – a recipe for national debt to rise not fall.