LONDON: Spanish government bonds fell on Thursday before a big test of appetite for its debt at an auction that could be challenging due to uncertainty over what the European Central Bank will decide at its policy meeting later.
Expectations earlier this week had been high for some bold policy response to the three-year old euro zone debt crisis after ECB President Mario Draghi pledged last week to do whatever was necessary to preserve the euro.
But German officials have since poured cold water on such promises, narrowing the scope for radical action and prompting markets to scale back their bets.
The uncertainty makes for a difficult backdrop to a 2 to 3 billion euro sale of Spanish debt maturing in 2014, 2016 and 2022, at which borrowing costs are seen rising.
"You are either betting that Mr. Draghi is going to win this particular battle and deliver on what he has hinted at... or staying away and saying well if he doesn't deliver it's just going to go straight back to 7.5 percent," Marc Ostwald, strategist at Monument Securities said, referring to Spanish 10-year borrowing costs.
"The best that one could hope for is that they sell the full 3 billion and I suspect that it will probably be with a greater bias towards the shorter-dated paper."
Ten-year Spanish were up 2.1 basis points at 6.76 percent, with short-dated bonds underperforming. Five-year yields rose 9.2 bps to 6.27 percent, while the two-year equivalent firmed 9 bps to 4.80 percent.
"(The Spanish auction will be) tricky," one trader said.
"The average price might be fairly in line with market, but we could get massive, long tails."
A wide tail - the difference between the lowest and the average bid - tends to indicate a lower quality of bids.
DRAGHI'S D-DAY
A poor auction would only raise the stakes for the ECB meeting, exacerbating any market reaction if Draghi fell short of market expectations, analysts said.
Draghi faces the biggest test of his nine months' leadership of the ECB, and any signs that he overplayed his hand could hit peripheral euro zone bonds.. He holds a news conference at 1230 GMT. No interest rate change is expected.
His comments last week fuelled expectations that, at the very least, the ECB would resume its bond-purchasing programme in a bid to cap borrowing costs of Spain and Italy.
For markets, analysts say, the best case scenario would be that this happens in tandem with the EFSF rescue fund buying bonds in the primary market. But that would be a long shot as it would require Spain to seek EFSF aid - a move it has resisted.
"If they simply say we are going to buy bonds then initially the market will probably react positively," Elwin de Groot, senior market economist at Rabobank, said.
In such a scenario, the yields spread of Spain and Italy against German Bunds would narrow and their curves would steepen, with short-dated bonds benefiting the most.
"If the ECB gets back into the market, then obviously no trader or hedge fund will take a big risk and short the paper." Inaction would see yields on Spanish government bond yields test euro-era highs of 7.78 percent made last week, de Groot said, and even promises of future action may not be enough to prevent further selling in the periphery.
"I am inclined to say that if it stays with only promises we could still see a negative market reaction, albeit perhaps more limited," de Groot added.
The yield spread between Spanish and German bonds held relatively steady at 539 bps, down from 613 bps the day before Draghi's comments.
German Bund futures were up slightly, 10 ticks higher at 143.61.
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