EURO GOVT-Bunds dip ahead of Spanish auction

Thu Apr 19, 2012 3:45am EDT

Related Topics

* Bunds dip ahead of Spanish auction

* Sale seen going well but relief short lived

* France to sell 11 bln euros of bonds

By Kirsten Donovan

LONDON, April 19 (Reuters) - German government bonds edged lower on Thursday but benchmark 10-year yields held within a whisker of all-time lows ahead of Spanish debt auctions that will test investor confidence and set the near-term tone for peripheral debt markets.

Spanish 10-year bond yields were little changed around 5.84 percent ahead of the sale of up to 2.5 billion euros of 2014 and 2022 bonds.

Yields on its debt have fallen in the secondary market in the previous two sessions as dealers covered short positions ahead of the auction after a decent T-bill sale on Tuesday.

"A positive outcome is already in the price but even if you do get a better-than-expected result that would merely represent a stay of execution rather than a commuting of the actual sentence," said Rabobank rate strategist Richard McGuire.

"Positive auctions are just stepping stones to the next negative result ... which is likely to happen sooner rather than later."

Concerns over Spain revolve around whether the country can carry out further austerity without choking the economy and the extent to which leveraged domestic banks have become vulnerable to another blow-out in peripheral debt markets.

Thursday's sale will be helped by the small target size, 15 billion euros of coupon and redemption payments due at the end of April and a shortage of the two bonds in the secured lending, or repo, market.

"Spain have really done everything they can do to make sure this auction goes well," said a trader. "The recent tightening is all about positioning but focus will return to fundamentals eventually."

With markets positioned for a successful outcome, any disappointment could see Spanish 10-year yields head back towards 6 percent and Bunds test their recent highs. Italian bonds would also be likely to come under pressure ahead of auctions next week.

But even a positive result is unlikely to take the pressure off the sovereign for long.

"The main point to watch for is whether there is much demand post auction: solid price action may well encourage further (closing of short positions), but we expect investors to overall be wary of initiating new longs," said Credit Agricole rate strategist Peter Chatwell.

"Any spread-tightening post auction could well be short lived."

With the relatively small target size, traders have speculated that Spain may sell more debt than indicated and Commerzbank strategists added that anything below 2.5 billion euros would be seen as a disappointment.

They also said the split between the two-year bond, which can be supported by funds from the European Central Bank's three-year funding operation, and the 10-year bond would be important.

"The still very steep shape of the 2-10 year (Spanish yield curve) could tempt the Tesoro to skew supply towards the short-end, while the market will look for how much can be placed comfortably in the 10-year area," said Commerzbank strategist David Schnautz.

France will also sell up to 8 billion euros of long-term debt, including new two-year bonds and up to 3 billion euros of inflation-linked paper, with the auctions expected to go smoothly.

German Bund futures were 21 ticks lower at 140.15, with 10-year yields up almost 3 basis points at 1.66 percent but still within sight of this week's record lows of 1.622 percent.

"A positive Spanish auction could underpin a risk-on move and a tightening of peripheral spreads but that does not challenge the longer-term view ... the path of least resistance is for lower core yields and a bull flattening of core yield curves," Rabobank's McGuire said, referring to a curve flattening led by a fall in longer-dated yields.

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