By Emelia Sithole-Matarise and Marius Zaharia
LONDON, April 3 Spain led peripheral euro zone bond yields up on Tuesday as the country's financial problems stoked concerns about the currency bloc's ability to keep budget deficits under control.
Spain said in its budget presentation that its debt levels were set to jump this year to their highest levels in 22 years, pushing its 10-year yields 10 basis points to 5.46 percent.
"We have deteriorating news from the periphery, I don't think the market liked the Spanish budget too much ... some of the data there is pretty weak," one trader said, pointing to a rising debt-to-GDP ratio in Spain's economic forecast.
Spain's public debt will reach 79.8 percent of gross domestic product in 2012, up from 68.5 percent expected in 2011, a document detailing the country's 2012 budget showed on Tuesday.
Spanish bonds are seen staying under pressure before auctions on Wednesday of up to 3.5 billion euros of debt with some market participants also taking Spain's intention to issue less 15-30 year paper this year to signal more 10-year bonds than initially thought.
"It means the 10-year part of the curve is going to have more supply coming into the market so that should pressure Spanish bonds," said Achilleas Georgolopoulos, a strategist at Lloyds Bank.
Spanish bonds underperformed Italian counterparts, widening their 10-year yield spread by six basis points to 30 basis points.
Before the presentation of the budget document, investors were already jittery after data showed Spanish unemployment rose for an eighth straight month in March, highlighting the recession risks in the euro zone.
Markets expect European Central Bank President Mario Draghi to acknowledge the relative weakness of the bloc's economy in comments after Wednesday's interest rate-setting meeting and to suggest a wait-and-see attitude.
With markets driven mainly by the ECB's massive liquidity injections in the first quarter, analysts expect economic data and political activity in Spain and Italy to take centre-stage in coming months.
"What is anecdotally important is that yields are no longer falling for Italy and Spain ... the support from liquidity is starting to fade," Commerzbank rate strategist Rainer Guntermann.
He said it was too early to call for a lasting rising trend in Spanish yields, but warned that the recent calm in markets could quickly dissipate. Any budget slippage would lead the market to expect further austerity, which in turn would deepen the recession and hurt budget revenues, Guntermann said.
Benchmark German bonds pared losses as the periphery came under pressure, with Bund futures down 13 ticks on the day to settle at 138.29.
German 10-year yields ended the session 1.1 basis points lower at 1.80 percent. Investors expect a neutral policy stance from the ECB which would keep 10-year German yields within the tight 1.8-2.10 percent range they have mostly traded so far this year.
The main risk to investors' expectations of a neutral tone from the ECB is that Draghi could signal he might give in to pressure from some of his colleagues who think the bank needs to prepare to withdraw some of the 1 trillion euros of cheap three-year funds it injected into the banking system.
"The Bundesbank is increasing the pressure (on Draghi) to come up with at least some teasing words to calm down (inflation worries)," said Michael Leister, rate strategist at DZ Bank.
Such an outcome could increase selling pressure on bonds across the euro zone, especially in highly indebted Spain and Italy, whose markets benefited the most from the ECB's cash injections.
"(Markets) are looking for a fairly benign outlook. Talk of exit is a bit premature," one trader said.
Bunds would react less, as some cash withdrawn from peripheral markets would be re-invested in Germany. The technical picture also points to a narrow near-term range.