Market confidence in Spain wanes after poor Treasury bond auction

Market confidence in Spain’s ability to meet its deficit-reduction target when the economy is in recession waned on Wednesday after the weak outcome of a government bond auction.

Spain’s risk premium rose to its highest level since November of last year, while the stock market fell sharply for the second session in a row, pulling other European bourses lower in what could shape up to be the next phase of the euro zone crisis. Market operators reported that the Spanish bond auction had caused the euro to slide against the dollar.

Prime Minister Mariano Rajoy again defended the draconian state budget, details of which were revealed on Tuesday, as Navarre said it may join Basque provinces in not applying the amnesty for tax dodgers included in it.

“The budget is hard, disagreeable and uncomfortable; no one likes it but the alternative is infinitely worse,” Rajoy said. “The situation is definitely very difficult, and even more difficult when in the short term, the reforms won't produce the desired effects neither outside or inside Spain, but I assure you they will produce them in the medium and longer term.”

Rajoy said in the next few months his main priority would be to set the budget stability in motion. “Regions and city halls have to comply.”

While refusing to mention specific countries European Central Bank President Mario Draghi said the markets want more reforms.

The Treasury issued close to the minimum planned in government bonds at higher rates in what was the first debt auction after the budget, which includes savings of 27 billion euros to cut the deficit to 5.3 percent of GDP from 8.5 percent last year at a time when the economy is expected to shrink by 1.7 percent.

The Economy Ministry’s debt-management agency sold 2.590 billion euros in three-, four- and eight-year bonds when it had been targeting to issue between 2.5 and 3.5 billion euros.

It sold 1.127 billion euros in bonds maturing at the end of January 2015. The average yield rose to 2.890 percent, up from 2.440 percent at an auction held in March. It issued a further 973 million in bonds maturing at the end of October 2016. The average yield was 4.319 percent, almost a full percentage point above the level of a month ago. In the last leg of the tender, it sold 489 million in eight-year bonds as the average yield rose from 5.156 percent to 5.338 percent.

Demand for Spanish debt in the primary market had been strong as a result of the ECB’s massive injection of three-year money at an interest rate of 1 percent as part of its Long-Term Refinancing Operations (LTRO).

“It’s back to reality now,” Bloomberg quoted Peter Chatwell, a London-based fixed-interest strategist at Crédit Agricole Bank, as saying. “The auction shows the LTRO effect has been exhausted and now demand for Spanish paper is becoming much more price sensitive.”

“Today’s auction almost certainly presages a turning of the tide for Spain,” Reuters quoted Nicholas Spiro, managing director of Spiro Sovereign Strategy, as saying. “That the level of issuance was low to begin with makes the result all the more disappointing.”

The Treasury has already completed 47 percent of the long-term debt issues planned for the year, and a third of all issues of about 186 billion euros.

The budget announced Tuesday by Finance Minister Cristóbal Montoro estimates that Spain’s public debt will rise to 79.8 percent of GDP from 68.5 percent at the end of last year. It expects interest paid on that debt to rise 5.3 percent to 28.848 billion euros.

The heightened concerns about Spain were reflected in its risk premium. The spread between the yield on the Spanish benchmark 10-year government bond and the German equivalent widened by 25 basis points to 290 basis points, its high for the year.

The reaction in the stock market was also negative. After shedding 2.71 percent on Tuesday, the blue-chip Ibex 35 index closed down 2.09 percent at its low for the year of 7,660.70 points. The DAX in Franfurt shed 2.84 percent, while the CAC 40 in paris was down 2.74 percent.

Spain is hoping to ward off the fate of its Iberian neighbor Portugal, which on Wednesday marked one year since its 78-billion-euro bailout program with the International Monetary Fund and the European Union began.

Portugal’s debt-management agency IGCP on Wednesday successfully sold 1 billion euros in 18-month bills, the longest maturity it has issued since receiving the rescue funds. The average yield was 4.537 percent, with demand exceeding the amount sold by 2.6 times.

The European Commission said on Tuesday it expects Portugal to be able to return to the financial markets for its funding next year, but adding the telling rider that the markets would have the final say in the matter. That may also apply to Spain.