EURO GOVT-Fall in Spanish yields seen brief as debt sale looms
* Spain in recession but contraction less than forecast
* Thursday's Spanish bond sale seen tougher after S&P cut
* German Bund futures could retest record highs
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, April 30 (Reuters) - Spanish government bond yields fell on Monday after data showed the country's economy contracted less sharply than forecast, but they were expected to pick up again before debt sales on Thursday, the first for Madrid since last week's ratings downgrade.
Spanish 10-year yields dropped to 5.80 percent, 11 basis points lower on the day, but strategists say the battle against the psychologically important 6 percent level has not been won yet, as markets remain in crisis mode.
Although marginally smaller than the estimates of the central bank and other economists, the economic contraction in Spain still raises concerns that the austerity measures planned by the government could do more harm than good.
"Even though the Q1 numbers have surprised on the upside in terms of what the central bank had given us in terms of their own estimates, the tendency in the economy is to get worse not better," said Ricardo Barbieri, a strategist at Mizuho.
"Going forward I will be sticking to an underweight in Spain. I'm not betting on a Spain turnaround," he said.
Moves have been exacerbated by thin volumes, traders said, and transactions with Spanish and Italian bonds were dominated by short-term investors.
The room for further falls in yields looked limited before Spain's sale of up to 2.5 billion euros of three- and five-year bonds on Thursday, its first debt auction since Standard & Poor's cut the country's credit ratings by two notches last week.
The downgrade pushed yields briefly above 6 percent. A sustained break above that mark could see borrowing costs accelerate to the panic-inducing levels over 7 percent that forced Greece, Portugal and Ireland to seek bailouts.
Although Italian debt yields have been caught in the Spanish updraft, Spain looked set to underperform Italy - which has no scheduled bond sales this week - before Thursday's auctions.
The premium investors require to hold 10-year Spanish bonds rather than Italian debt stood at 25 bps, bang in the middle of the trading range since early March, when Spanish yields rose above Italian yields.
"It appears that the focus is in large part on Spain, and the balance of risk is that Spain will underperform," Nordea chief analyst Niels From said.
A way to place bearish bets on Spain other than trading it outright or against Italy is to position for the underperformance of benchmark bonds versus their neighbouring bonds on the Spanish curve, JPMorgan strategists said.
Specifically, they recommend betting on a widening of the spread between the January 2022 benchmark and the April 2021 bond, which is now 10 basis points.
Peripheral euro zone debt is likely to remain vulnerable over the next few days, as market nerves are stretching before Sunday's French presidential runoff and the Greek elections.
If it intensifies, "the risk off mood" could push benchmark 10-year German Bund yields to record lows beyond the 1.549 percent hit in April and the two-year Schatz yield into negative territory, Nordea's From said.
Ten-year yields were last 4 bps lower at 1.66 percent, while two-year yields were down 1.4 bps at 0.88 percent.
"There seems to be support at 1.63 percent in the 10-year (at last week's lows), but it could be broken if the Spanish situation deteriorates," From said.
"From a fundamental perspective Bunds look very expensive, but when considering the situation in the southern Europe (new record lows) should not be excluded."
Bund futures were 39 ticks higher at 141.39. a break above the 141.38 record high hit last week "will be the next bullish signal, opening the door to 141.56, then even the 200 percent extension level at 144.04," UBS technical analyst Richard Adcock said.