Spain Faces ‘Surreal’ Situation, Despite Strong Bond Auction

Optimism is increasing in the bond markets about Spain’s immediate future as investors bet the country will seek a full bailout from the European Central Bank, though it’s still far from a done deal, as analysts and economists point out.


On Thursday, an auction of 4.5 billion euros ($5.8 billion) in three-year and 10-year Spanish bonds proved successful, with 10-year paper hitting a lower-than-expected yield of 5.666 percent.

This is substantially lower than the record highs of 7.62 percent seen on 10-year yields just before European Central Bank (ECB) President Mario Draghi made his “whatever it takes” speech in late July. Since then, the ECB has announced high-profile plans to shore up Spain’s borrowing levels, which many in the market have interpreted as offering a back-stop to Spanish bond yields for now. (Read More: ECB's Bond-Buying Plans.)

“There's a surreal air to Spanish debt auctions right now: The sales are well received, mainly because investors expect Madrid to eventually request an ECB-backed bond-buying program,” Nicholas Spiro, managing director of Spiro Sovereign Strategy, wrote in a research note.

The Spanish prime minister, Mariano Rajoy, and his cabinet will be studying the results of the auction closely as they continue to debate the best course of action.

There is also some comfort from Standard and Poor's head of EMEA sovereign ratings, Moritz Kraemer, who said on Wednesday that Spain is unlikely to lose its investment grade rating.

Meanwhile, pressure continues to build on Spain’s government to make a decision. According to a report in Spanish newspaper El Pais on Thursday, the government would like to use part of its 100 billion euro banking bailout package to avoid a full sovereign rescue. However, Spain’s euro zone partners have not yet indicated whether they would be amenable to such a plan.

The impact of the ECB’s action will be felt “significantly” by Spain next year, according to economists at Citi.

There have been a raft of downgrades for Spain’s growth by economists this week. Citi economists cut their 2012 growth forecast to -1.8 percent from -1.7 percent, and raised their 2012 deficit forecast to 6.6 percent of gross domestic product (GDP) from 6.5 percent. Barclays also cut forecasts for Spain’s GDP, expecting growth to decline 1.8 percent in 2012, and the deficit to come in at around 7 percent of GDP. (Read More: Growing Pressure on Spain)

The Spanish government appears to want to have its bailout and eat it, without any of the nasty conditions attached that have caused problems in other bailed-out euro zone countries.

The “close monitoring” by international lenders which has been part and parcel of other bailouts is what Spain is trying to avoid, economists at Citi pointed out.

They predict a full bailout for Spain before the end of the year, or early 2013 at the latest.

The indebtedness of Spain’s regions are adding an extra level of complication which could make it even more difficult for Spain to impose austerity conditions. A key meeting between Rajoy and Artur Mas, president of the Catalonia region, which has historically agitated for independence, on Thursday is expected to be fractious. Mas is not keen on the austerity plan proposed for his part of Spain. He is also trying to use the opportunity to wrest more control over tax to the regional government.

“There are still many pieces, particularly political ones, which would need to fall into place over the coming days and weeks in order for Madrid to feel compelled to request a program and for the program itself to be approved and launched,” Spiro of Spiro Sovereign Strategy warned.

—By CNBC’s Catherine Boyle; Follow Her on Twitter @catboyle01