MADRID: Spanish medium-term bond yields are set to rise sharply at an auction on Thursday compared with the previous sale, while markets will watch closely for signs that local banks' appetite for the country's debt is faltering as ECB funds run out.
The auction is the first since Standard and Poor's cut Spain's credit rating by two notches to BBB+ last week and follows confirmation from the National Statistics Institute that the economy has slid into its second recession since late 2009.
Spanish banks, virtually cut out of wholesale debt markets after losing billions when a decade-long property bubble burst in 2008, were eager takers of the cash the European Central Bank pumped into the euro zone banking system in December and February, in operations totalling almost a trillion euros.
Recent data from the Bank of Spain appears to support suggestions that they used much of the ECB's ultra-cheap three-year money to buy up high-yielding sovereign debt.
According to the Bank of Spain, Spanish lenders held just over 13 percent of domestic debt in November 2011, but that total had soared to almost 30 percent by March. Similarly, non-residents held almost 56 percent of all Spanish debt in November, but by March, that proportion had fallen to 38.8 percent.
With the ECB long-term refinancing operation (LTRO) cash running low on banks' balance sheets, markets are looking to see when Spain's institutions will start to shy away from domestic debt purchases.
"There's a reasonable argument to say that borrowing costs would be a lot higher than they are if the (ECB) mechanism was not in place," European economist at Capital Economics Mark Miller said.
"The further you move into this year and early next year, debt servicing costs might easily become a significant issue and increase the chances that Spain will need some kind of bailout in the future."
Spain has jumped back to the forefront of the euro zone debt crisis - after a brief honeymoon period for the new conservative government - on concerns that Prime Minister Mariano Rajoy will not be able to shrink one of Europe's highest public deficits.
The government has introduced a slew of savings, cuts and market reforms to tackle the deficit and boost competitiveness, but with unemployment sky-high and the economy again contracting, many worry it won't be enough.
With property prices still falling, some economists say the government may eventually be forced to refinance the banks with public money, putting further pressure on straining coffers, or apply for international aid. Spain's banks have been told by the government to raise more than 52 billion euros to reinforce their balance sheets.
The Treasury aims to issue between 1.5 billion and 2.5 billion euros ($1.99 billion-$3.31 billion) of bonds on Thursday, maturing on July 30, 2015, Jan. 31, 2017 and July 30, 2017.
On Tuesday, in low-volume trading with many investors absent for the May Day bank holiday, the 2015 bond was trading at a yield of 3.95 percent, the Jan. 2017 at 4.7 percent, and the July 2017 at 4.85 percent.
Yields on the 2015 and Jan. 2017 bonds were more than a percentage point higher on the secondary market than when they were last sold earlier this year, a good indication of the premium the government may have to pay at the auction.
"That the yields will rise is a given. What will be interesting is whether the domestic banks continue to buy into the auctions or if they're starting to reach their limit," strategist at BNP Paribas Ioannis Sokos said.
The relatively small target amount at the auction, after a heavy issuance programme in the first four months of the year, would help demand, Sokos added.
After Spain's last bond auction, April 19, the Treasury had sold half of its gross issuance target for 2012.
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