LONDON: Spanish government bond yields eased on Thursday ahead of a debt auction when borrowing costs are expected to hit new highs with the country poised to formally request aid for its crippled banking sector.
Spain will sell up to a modest 2 billion euros of 2-, 3- and 5-year bonds, relying almost entirely on its domestic banks to absorb the issuance. Yields on the five-year paper are set to top 6 percent - the highest since before the introduction of the euro.
"Spain has never had any difficulty raising money, it's just the yield levels they will have to pay," said Rabobank rate strategist Lyn Graham-Taylor.
"Although there's been a big rally in the last couple of days, yields are still at highly elevated levels but the auction should be supported by the small size and short maturities."
Ten-year Spanish government bond yields were 9 basis points lower at 6.67 percent after rising to close to 7.30 percent last week.
"There are a couple of domestic banks on the buyside with no one on the other side so it's pushing the market higher ahead of the auctions," a trader said.
"But people are reluctant to trade or make prices and we shouldn't over-analyse it. The market is closing its eyes and trading a little blindly on the hopes things are getting better, but there's nothing concrete, only the usual noise."
Spanish and Italian bonds have rallied this week, and Bunds fallen, on speculation Europe's bailout schemes may be used for buying sovereign bonds in the secondary market. Germany's Angela Merkel, however, said that was not being discussed.
After the debt sale, Madrid will release the results of an independent audit of its banks - many of which are suffering from a rising number of bad real estate loans - and possibly make a formal request for European Funds to prop them up.
Euro zone finance ministers have already agreed to lend Spain up to 100 billion euros to rescue its banking sector but analyst increasingly believe the country will need a full bailout.
"With Spain under increasing pressure on capital markets, the spectre of having to exhaust European Stability Mechanism resources with an official rescue of Spain looms large," ING rate strategists said in a note.
ING said that with a full rescue package for Spain likely to cost around 250 billion euros, taking into account funds already committed to Greece, Ireland and Portugal would leave only around 150 billion euros in the kitty.
"If beyond that Italy were to require help we would enter very dangerous territory," ING said.
"There is no rescue mechanism in place that could cater for an Italian bailout."
German Bunds also rose, after hitting their lowest level in nearly eight weeks on Wednesday, supported by data showing that the downturn in the euro zone's private sector is becoming entrenched as falling new orders and employment levels dent confidence.
September Bund futures were 43 ticks higher at 140.92. Ten-year yields were three basis points lower at 1.58 percent but more than 30 basis points above their all-time lows hit at the beginning of June.
"If a few big hedge funds decide selling Bunds is the trade for the next couple of weeks, then, in these reduced volumes, it will be the trade," the first trader said.
"But Bunds have backed up a lot ... and they're becoming attractive again."
France will also sell up to 8.5 billion euros of medium-term and inflation-linked bonds on Thursday.
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