* Spanish bonds hit by two-notch downgrade to BBB+
* Italian yields also rise despite smooth auction
* Focus likely to turn to U.S. data for signs of recovery
By William James
LONDON, April 27 (Reuters) - Spanish bond yields rose to the 6 percent danger level on Friday after a credit rating downgrade stoked fears about the euro zone’s heavy debtors, with a smooth Italian debt auction providing only limited relief.
Standard & Poor’s cut Spain’s credit rating by two notches to BBB+ late on Thursday and maintained a negative outlook, citing the deterioration of government finances and weakness in the Spanish banking sector.
In reaction, the 10-year Spanish bond yield hit a high of 6.03 percent, up 18 basis points on the day. The rise also reflected weak Spanish retail sales data and the threat of further downgrades.
“It’s difficult to see where any good news for Spain comes from ... people are perhaps taking the view that now the downgrade has come for Spain, what could happen to Italy on that front?” said John Davies, strategist at WestLB in London.
The Spanish yield has briefly broken above 6 percent several times in recent weeks. Markets are wary that a sustained move would draw comparisons with the swift rise to an unsustainable 7 percent seen in Portuguese and Irish yields before both countries sought international bailouts.
The scale of the region’s debt problems were highlighted by S&P’s head of European ratings, Moritz Kraemer, who said there were downside risks to almost all euro zone sovereign ratings.
Nevertheless, Italy was able to negotiate a potentially tricky bond sale with the minimum of fuss, selling 5.95 billion euros of BTPs and avoiding the poor show of demand that some had feared following the deterioration in sentiment.
“To sum up, at least no further bad news, nothing to provide further fuel to the sell-off we have had in periphery paper this morning,” said Michael Leister, strategist at DZ Bank.
The 10-year Italian bond yield rose 14 bps in early trade to hit 5.78 percent - its highest level since the beginning of February. It was last trading at 5.74 percent as the smooth auction took some of the heat out of the selloff.
German Bund futures rallied to a record high 141.38 as investors sought out low-risk assets, but retreated after the Italian auction to stand 4 ticks higher at 140.96.
However, with peripheral yields at elevated levels - 10-year borrowing costs rose by 60 bps compared with a month ago at the Italian auction - Bunds were likely to remain the investment of choice for those looking to cut back on risk.
“Even though Italy and Spain have come back from their wides, the market there still seems a little soft... they say ‘don’t ever be short Bunds on a Friday’, so we could get back up a bit towards new highs,” a trader said.
After euro zone data earlier this week painted a grim outlook for the region’s economy, investors’ next focus will be the health of the U.S. recovery when it unveils first quarter output figures at 1230 GMT.
The data is expected to show the rise in gross domestic product slowing to an annualised rate of 2.5 percent from 3 percent in the previous quarter.
Economic growth is an essential component of Spanish and Italian plans to escape their towering debts and any negative surprise from the world’s largest economy would fuel selling pressure on riskier euro zone bonds.
“We’re back in that situation where we have euro zone troubles and at the same time concerns about the strength of the U.S. recovery,” said Philip Marey, strategist at Rabobank in Utrecht.