Spanish bonds face FOMO after Rajoy’s ‘drubbing’

The real loser in Catalonia’s referendum was, of course, Spanish Prime Minister Mariano Rajoy. He needs to
make sure that his country’s bond market doesn’t follow suit.
The regional election he demanded resulted in the three separatist parties winning 70 out of the 135 seats. But the pro-independence parties did not win an overall majority of votes, and forming a government may prove a real challenge.
For markets it doesn’t look like an immediate game-changer, just more protracted wrangling ahead, so they’ve recouped some early losses. The benchmark IBEX 35 equity index is now just one percent lower and the euro has recovered most of its overnight losses versus the dollar.
While 10-year Spanish government bonds are 4 basis points wider from yesterday, they’ve retained some of their gains this week versus the German benchmark. And that is without support from the European Central Bank QE buying program, which is on hold until the New Year.
This appearance of strength is misleading. Yields have flat-lined this year in comparison to its neighbors, particularly Portugal, which is far more indebted as a percentage of gross domestic product.
This under-performance ought to be sending a message to the prime minister, namely, that his hardball tactics haven’t worked. Spain’s services PMI has fallen from a high this year of 58.3 in June to 54.4 in November.
Catalonia is still technically under central government control, and it is hard to justify that continuing indefinitely after this election result. Against this political backdrop, the technical pressure in the bond market is building. To start, there is substantial new-issue supply coming. Spain could well issue a syndicated new 10-year next month, having raised about 10 billion euros ($11.9 billion) every January for the past four years. The environment would be considerably more difficult this time since, like most other countries in Europe, it will be raising more money just as the ECB halves its QE buying.
If Spain is not to lose ground in its economic recovery, and participate in the resurgence that the rest of Europe is enjoying, the Rajoy government needs to find a workable solution to this local difficulty. If he keeps to his strong-arm approach, the bond market will underperform, so the nation’s financing costs will be higher than they need to be. And could land him with a serious political cost.

—Bloomberg