* 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
LONDON, April 30 (Reuters) - Spanish government bond yields slipped on Monday after data showed the country’s economy contracted less sharply than forecast but they were expected to pick up before debt sales later this week, the first since last week’s ratings downgrade.
Spanish 10-year yields were last at 5.89 percent , 2.1 basis points lower on the day. Spain’s gross domestic product shrank 0.3 percent in January to March on a quarterly basis, beating economists’ forecasts for a 0.4 percent contraction.
The figures will do little to change investors’ view that the euro zone’s fourth largest economy will struggle to meet budget targets as it falls back into a recession exacerbated by an ailing banking sector, traders and strategists said.
“In our view it doesn’t make a huge difference...The economic performance will be a function of whether credit will be able to flow again in the economy so the banking issues remain at the core,” UBS strategist Gianluca Ziglio said.
“We need to see which practical ways the government is going to tackle this issue. We’re going to have the auctions on Thursday and that’s going to be another element of volatility for Spanish bonds,” he said.
A sustained break above 6 percent on 10-year Spanish yields could see borrowing costs accelerate to the panic-inducing levels over 7 percent that forced Greece, Portugal and Ireland to seek bailouts.
Some strategists and traders said the yields could breach 6 percent if Spain struggles to sell three- and five-year bonds on Thursday - its first sale since Standard & Poor’s surprised markets with a two-notch downgrade of its ratings last week.
Although Italian bond yields have been caught in the Spanish updraft, Spain looked set to underperform Italy - which has no scheduled debt sales this week - before Thursday’s auctions.
“We have a strong case for Spain to continue to underperform Italy with Spain under pressure on ratings jitters, upcoming supply, while Italian supply is out of the way,” Commerzbank strategist Rainer Guntermann said.
The 10-year Spanish/Italian 10-year yield spread was last at 26 basis points, a touch wider compared with late Friday levels.
The fragility in peripheral euro zone debt and nerves over Sunday’s French presidential runoff propped up German benchmarks.
Investors are also waiting to see if the European Central Bank gives any hints of future support for the market at its policy meeting on Thursday.
U.S. non-farm payrolls numbers follow on Friday after weaker than forecast Q1 GDP data bolstered those hoping for further stimulus from the Federal Reserve.
The June Bund future was last seven ticks up at 140.77. It reached a contract high of 141.38 on Friday as Spanish yields briefly topped 6 percent after the S&P downgrade.
UBS technical analyst Richard Adcock said a “break above 141.37/38 will be the next bullish signal, opening the door to 141.56, then even the 200 percent extension level at 144.04”.
German 10-year yields were last slightly lower at 1.70 percent with some strategists saying they could retest the record low of 1.549 percent hit last Monday with month-end related buying keeping yields subdued.
“We’re still buying dips in Bunds. The ECB could tone down their language a bit this week and people are looking at payrolls on Friday. If it comes in soft Treasuries and Bunds are likely to go up again,” a trader said.