Spanish yields rise after Moody's rating threat

Spanish government bonds underperformed other euro zone debt on Wednesday as the market braced for a bond sale this week after rating agency Moody's said it may cut Spain's credit rating.

Moody's put Spain's Aa1 rating on review for downgrade, citing Madrid's high funding needs, doubts over its banking sector and concerns over regional finances.

Spanish 10-year government bond yields were 3.5 basis points higher at 5.586 percent, off earlier highs close to 6.5 percent, on small amounts of buying, traders said.

That left the spread over benchmark German Bunds at 254 basis points, although some of the pressure was due to selling ahead of a 10- and 15-year Spanish bond auction on Thursday.

"The Moody's review is hardly a surprise, and they are not citing anything which the market has not already priced in," Credit Agricole rate strategist Peter Chatwell said.

"But markets do move to a state of heightened alertness when one rating agency moves on the assumption that there are more to come."

The Moody's move followed Standard & Poor's cutting its outlook on Belgian debt to negative on Tuesday. A one notch Spanish downgrade would bring the Moody's rating into line with S&P's AA rating.

Spain paid dearly at a T-bill sale on Tuesday and is expected to pay a heavy premium at its longer-dated bond sale.

Chatwell said the market was building in a concession, with 10-year Spanish bond yields already more than 90 bps higher than their Italian equivalents. He added that there was room for further cheapening in a thin year-end market.

The bid/offer spread on the 10-year bonds was around 65 bps, according to Tradeweb, reflecting market illiquidity.

Madrid must pay 5 billion euros of coupons in January, 18 billion euros of coupons and redemptions in April, and around 22 billion euros in July, according to Reuters data.

Portugal, another highly-indebted peripheral euro zone state, sold 500 million euros in three-month treasury bills with borrowing costs rising sharply from the previous sale.

German government bonds were steady after a choppy morning's trading, finding support from the underperformance of the higher-yielding euro zone issuers.

However, weakness in U.S. Treasuries after the Federal Reserve showed no sign of curtailing its stimulus measures [ID:nN14232588], capped Bunds. The Fed decision on Tuesday, along with strong retail sales data, enhanced expectations of higher growth in the world's largest economy.

"The principle being the Fed are leaving the taps open with data supposedly recovering, but the Fed are not watching retail sales, they are watching unemployment," said Charles Diebel, head of rates strategy at Lloyds TSB.

"However you can't rule out further weakness in Treasuries... and then supply is hanging over the euro zone market like the sword of Damocles going into next year."

The yield on 10-year U.S. Treasuries hit a seven-month peak above 3.5 percent before easing back.

Bunds Choppy

March Bund futures were five ticks higher at 124.07, rebounding from eight-month lows of 123.76.

"The Spain (outlook) downgrade seems to have stopped the rot in the core," a trader said. "It refocuses attention on who is going to be next in the euro zone."

Two-year German bond yields were flat at 1.084 percent, with 10-year yields up 2 bps at 3.041 percent, having tested strong resistance around 3.08 percent, the 38 percent retracement of the fall in yields since the financial crisis began in late 2008.

[Source: Kirsten Donovan, Reuters, London, 15Dec10].

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