EURO GOVT-Spanish yields rise as Moody's downgrades regions

Tue Oct 23, 2012 6:49am EDT

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By Emelia Sithole-Matarise

LONDON, Oct 23 (Reuters) - Spanish bond prices fell on Tuesday after Moody's downgraded five of the country's regions including economically important but deeply indebted Catalonia, while safe-haven German bonds gained.

Moody's, whose surprise decision to affirm Spain's investment grade credit rating last week prompted a sharp rally in its bonds, cut the regions by one or two notches, citing their limited cash reserves and forthcoming bond repayments.

They included the northern region of Catalonia, which accounts for a fifth of Spain's economic output but is all but shut out of international markets, forcing it to request a state lifeline of just over 5 billion euros.

The downgrades added to market nerves over Spain, which were already starting to fray as Prime Minister Mariano Rajoy's government holds off from seeking a bailout which would enable European Central Bank support for the country's bonds. Rajoy said on Friday after a European Union summit that he had still not decided whether to seek aid or not.

Traders and strategists expect Spanish yields to drift higher in coming days but ruled out a sharp sell-off in the debt given the prospect of eventual ECB intervention.

"Recent comments indicated that Prime Minister Rajoy has no real urgency to request a bailout and that has taken some steam off the rally and the downgrade of the regions is adding to the negative newsflow," Commerzbank strategist Michael Leister said.

"The market is realising that the momentum we had with a lot of events last week will most likely not be followed up by a quick aid request by Spain and that's prompting some profit- taking. We don't expect a sharp correction but a bit of a pullback."

Spanish 10-year yields were last 3 basis points up on the day at 5.55 percent. Earlier in the day, they rose to 5.59 percent, retreating from a six-month low of 5.297 plumbed on Friday after Moody's kept the country's sovereign rating one notch above 'junk' status.

Two-year yields popped back above the 3 percent mark they broke for the first time in over a month last week.

"I don't see much scope for much of a correction but the trigger for the next rally in peripheral bonds is we see Spain requesting aid. Until then markets are going to be rangebound," RIA Capital Markets strategist Nick Stamenkovic said.

COMPLACENCY

Spain still managed to sell up to 3.53 billion euros in short-term debt, with demand supported by the ECB's announcement that it plans to buy debt of up to three years' maturity under its new scheme. Three-month borrowing costs rose slightly while those for Spain's six-month treasury bills fell.

RBC strategists recommended buying shorter-dated Spanish bonds after a dip in the price, saying they still expected Spain to apply for a precautionary credit line in coming weeks that could trigger the ECB purchases.

"However, setbacks could become more severe in case political complacency hampers a financial assistance programme to be done and dusted before year-end, readying the ECB to intervene as of early 2013 when supply is picking up again," they cautioned in a note.

The fragile tone in peripheral debt prompted safe-haven German bonds to claw back some of last week's losses. Bund futures were last 18 ticks up on the day at 140.05 while cash 10-year Bund yields were last 2 bps lower at 1.60 percent.

Lloyds strategists expect 10-year Bund yields to hold within a 1.45-70 percent range, with a drift towards the upper end of the range going into Wednesday's German sale of 4 billion euros of 10-year bonds as traders push for cheaper prices.

"But as we approach the top of the range in yield, we think the better risk/ reward is to buy on dips on further weakness," they said in a note.

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