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Why Bond Markets Are Dancing to Rajoy's Tune

Bloomberg

Spain's economy is sinking deeper into recession, experts agree that the country will miss its budget targets for the year and several European Central Bank (ECB) officials have said Spain urgently needs a bailout, yet the bond market is dancing to a completely different tune.

Spain's 10-year bond yield remains below 6 percent, 2-year yields are hovering around 3 percent and the benchmark stock index has rallied 8 percent over the last three months.

According to Nicholas Spiro, managing director of Spiro Sovereign Strategy, the market is doing the bidding of Spain's Prime Minister Mariano Rajoy who has so far avoided asking for a bailout from the European Union despite a deteriorating economic picture.

(Read More: Europe Enters Second Recession Since 2009)

Ever since the ECB announced its unlimited bond-buying program, the bond market has been hesitant to bid up Spanish bond yields for fear of central bank intervention. In fact, at the current yields, Spain has managed to complete its funding requirements for the year.

Pablo Blazquez Dominguez

"The market is not calling Mr. Draghi's bluff," Spiro said on Thursday. "This could last for months, the market is doing Mr. Rajoy's bidding."

Data released on Thursday showed Spain's economy contracted 1.6 percent in the third quarter, over the year-ago period.

"Spain urgently needs to call on the emergency aid," ECB Governing Council member Luc Coene was quoted as saying on Thursday. His comments follow former ECB official Lorenzo Bini Smaghi who told CNBC earlier this week that Spain needed a bailout"yesterday".

(Read More: Anti-Austerity Marches Turn Violent Across Europe)

Meanwhile, 800,000 people took to the streets on Wednesday to protest rising unemployment and the government's austerity measures, with some of the demonstrations turning violent.

In a sign that that the European Union is softening its stand towards Spain, the European Union's Economic Commissioner Olli Rehn said Spain won't need further austerity measures until the end of next year even though it is set to miss its deficit targets.

"Piling austerity on austerity is no longer the best way to deal with slippages, which in the case of Spain are massive," Spiro told CNBC. "Unfortunately the damage has been done and the room for maneuver for Spain is still extremely limited and the fiscal slack that Spain has been cut is still inadequate."

By CNBC's Deepanshu Bagchee; Follow Him on Twitter @DeepCNBC

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