Spain Takes Center Stage

The market is likely to remain volatile on account of global cues especially uncertainty regarding Greece. Absence of any positive trigger coupled with policy paralysis holding back the markets to form a rally. Markets are likely to remain under pressure until the Greece issue is resolved or some actions have been taken on the government’s part.

Greece’s inability to form a Government, which led to the country calling another election in June, has raised concerns about its ongoing membership of the euro zone and the health of the European economy. Greece has put a senior judge in charge of an emergency government to lead the nation to its second election in just over a month on June 17, which will likely determine whether it remains in the common currency area.

The euro touched a 23-month low today as fears mounted that Spain’s banking woes will push its borrowing costs to unsustainable levels while signs merged that China may move cautiously on stimulus measures to bolster its economy. Indications that China may take a cautious approach to stimulating its economy as growth weakens also dampened sentiment in the markets.

Spain’s sovereign credit rating was cut by Egan-Jones Ratings Co. to B from BB- on the country’s deteriorating economic outlook.  Earlier this week the country’s central bank said the economy will sink deeper into recession.

Focus on the shifting plans to recapitalize Bankia, the general escalation in the European crisis, the complication for Spanish funding as bond yields and CDS levels jump higher and China’s attempt to dampen speculation over its stimulus plans throw markets back into risk aversion, driving weak equity and commodity markets and a strong USD. There was some relief on headlines that the EU is willing to envisage direct ESM bank recapitalization and supports Eurobonds but this faded.

Markets were delivered a one-two punch late yesterday and overnight.  It started with the ECB decision following the North American close that it would not fund the recapitalization of Spain’s Bankia group. Facing few options, Spain then went on to confirm that it would fund recapitalization through more debt issuance.  Spanish 10s reacted by sharply selling off and sit at the increasingly dangerous 6.7% mark.

Spanish bonds have declined quite sharply since the past several days and the previous session was no exception either, as spread between the 10-year Spanish yields relative to benchmark German bunds widened the most since the Euro was created.

The yield spread against 10-year German bunds widened to more than 500 basis points, a record high, as concerns grew that Spain’s lenders will need additional financial support to weather Europe’s debt crisis. Meanwhile, global risk aversion is pushing the German bunds to a record low, which in turn is adding more pressure on the yield spread to widen.

As long as the ongoing banking concerns in Spain persists, Spanish government securities are likely to continue weakening further while demand for the safest assets such as German bunds would pick up. This in turn could lead to further increase in spread between the securities of Euro zone’s largest and 4th largest economy.

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