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Looking to the ECB for Help on Spain

Investors in Spanish bonds have lost faith in Prime Minister Mariano Rajoy and hope ECB head Mario Draghi will ride to the rescue.

Spanish bond yields soared to their highest level this year on Monday in reaction to new fears about the troubled country’s economic and financial system.

In stark contrast, the resulting rush away from Spanish debt and into safe havens pushed rates on German Bunds down to record lows. The situation raises the question of whether the European Central Bank (ECB) will ride to the rescue, as bank president Mario Draghi has indicated he stands ready to support troubled markets.

The most recent trigger for the jump in Spanish yields, which vaulted above the 6 percent mark for the first time since 2012 began, was provided by Friday figures that suggested that Spanish banks have become highly reliant on the country’s central bank in their struggle to avoid insolvency.

The Bank of Spain said net lending to the country’s banks rose to €228 billion ($174.3 billion) in March, compared with only €152 billion a month earlier. Much of this money ultimately comes from February’s emergency provision of three-year loans to financial institutions by the ECB, the central bank for the euro zone as a whole. The ECB had been spurred into action by the threat of another credit crunch in the banking sector.

At the root of Spain’s economic problems is the slump in activity caused by its property bust. This has pushed unemployment up to 23.6 percent, the highest among the 34 developed nations in the Organization for Economic Cooperation and Development. More than half of young people are jobless. Spain’s employment crisis has depressed demand — pushing Spain into recession in the first quarter of this year according to the Bank of Spain — and hit tax revenues. This has shaken confidence in the Spanish government’s ability to pay its debts — particularly since many analysts think the government may be forced to spend more money on bailing out the banks. Their books are afflicted with loans backed by property whose value has largely disappeared.

In the first two months of this year, yields on Spanish 10-year bonds fell from their late 2011 highs, but concerns about the country’s debt revived in March after the new prime minister, Mariano Rajoy, unilaterally announced an easing of deficit reduction targets agreed with the EU. He later hammered out a compromise target, amounting to 5.3 percent of gross domestic product, with EU economic and monetary affairs commissioner Olli Rehn — but the memory of Rajoy’s initial surprise move has left bond investors skeptical.

David Shairp, global strategist at JP Morgan Asset Management, said Rajoy’s “unilateral relaxation” of the deficit reduction targets had probably been “the original trigger for market concerns,” because it “signaled a waning resolve.”

The contrast with Bunds — the principal safe haven for investors in the euro zone — could not be greater. On Monday Spanish yields soared to as high as 6.16 percent — up 18 basis points (bps) on the day — before closing 10 bps higher at 6.08 percent. However, in response to renewed fears about Spain, yields on the Bund sank to a record low of 1.63 percent, before ending the day 2 bps lower at 1.72 percent. The spread between Spanish and German 10-years is now a cavernous 4.36 percent — 120 bps wider than at the beginning of March.

The strength of Bunds is based on Germany’s relative resilience compared with other euro zone countries. Although recent industrial production figures suggest Germany may, too, have entered recession in the first quarter of this year, its recent downturn has been relatively mild. The fall in the unemployment rate to a 20-year low has kept the German economy stable. Its fiscal deficit is likely to be only about 1 percent this year, far lower than estimates for the U.S. of about 8 percent. As a result, yields on Bunds are even lower than for U.S. Treasuries, which were 1.95 percent as the European afternoon closed.

Spain’s travails, however, have not yet created the same pervasive sense of crisis — both across nations and across asset classes — that prevailed in late 2011, when fears about Italy sparked the previous major euro zone debt scare. By late Monday, yields on Spanish 10-years were up 110 bps since the beginning of March, but yields on corresponding Italian debt were up only 42 bps over the same period to 5.60 percent.

The relatively sanguine response of other markets reflects a sense that many other euro zone governments, including Italy’s and France’s, have responded to last year’s panic by embracing painful reforms designed to balance their budgets. As a result, there is a greater sense that Spain’s problems are particular to Spain, founded largely on a lack of trust in Rojoy and other members of the Spanish government to place sufficient priority on debt reduction.

Some analysts remain optimistic that Spain is taking sufficient steps to resolve its long-term fiscal problems, leaving as the primary challenge its ability to survive market panic about its debt within the next few months. Deutsche Bank said in a Monday fixed-income note, “We continue to believe Spain’s challenge is liquidity, not solvency.”

In the past, the ECB has saved troubled debt markets by providing short-term liquidity through its Securities Market Program. Despite opposition to further such bond buying by some conservative euro zone central bankers, ECB president Mario Draghi has left the door open to it — declaring after this month’s rate-setting meeting that it was “premature” to talk of “any exit strategy” from loose monetary policy. Institutional investors in Spanish bonds are hoping the ECB is prepared to come to the rescue yet again.

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