Mind the yield gap: Spanish bonds cheer on new government (finally)

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It’s taken 315 days, but Spain finally has a government.

Incumbent prime minister Mariano Rajoy – who oversaw the country’s 2012 banking bailout – will lead a minority centre-right administration, finally breaking 10 months of governmental impasse in the eurozone’s fourth largest economy.

Bond investors are cheering the news, with Spain’s benchmark 10-year government bonds the best performing eurozone asset class on Monday. Yields on the 10-year bonds have slipped 3 basis points today to 1.19 per cent, while two-year debt is down 1bp. Yields fall when a bond’s price rises.

Two general elections and no government since last December have not proven fatal for Madrid’s borrowing costs, as European Central Bank asset purchases have kept 10-year yields below the 2 per cent mark over the last year.

But this weekend’s breakthrough – which will see Mr Rajoy’s Partido Popular back in office for a second term – has widened the yield gap between Spain and its fellow southern eurozone counterpart, Italy.

The spread between Spain and Italy’s 10-year yields has now widened to -0.46 percentage points – the largest on record, as investors hone in on an impending referendum, high levels of debt, a shaky banking system and sluggish growth in the eurozone’s third largest economy.

Soaring Italian and Spanish bond yields had forced the ECB to begin tentative steps to buy up Madrid and Rome’s government bonds under its Securities & Markets programme in 2011, and led to Mario Draghi’s landmark “whatever it takes” moment a year later.

But in a sign of diverging fortunes, Italy’s 10-year paper has now surged to its highest since February after prime minister Matteo Renzi defied Brussels’ attempts to rein in the country’s spending. In its latest draft budget plans for 2017, the centre-left Mr Renzi has promised to reduce Italy’s structural budget deficit to 2.3 per cent of GDP from an initial pledge of 1.8 per cent made earlier this year.

Mr Rajoy will also face a tussle with the European Commission over Spain’s budgetary targets after Madrid escaped a fine for failing to do enough to consolidate its public finances in May.

On Monday, Fitch Ratings welcomed the formation of a government in Madrid but warned “significant political risks remain”, as gridlock could well ensue in a parliament divided by the pro-austerity PP, Socialist party and grassroots anti-austerity movement Podemos.

“The PP minority government faces an inherent challenge in securing support for its policy agenda, including budget setting”, said Douglas Winslow at Fitch.

“This will be exacerbated by the Socialist Party’s calculations on supporting or opposing parts of the government’s agenda in response to the political challenge it faces from Podemos”, he said.

“There is a further risk that the government is unable to see out its full term, despite parliamentary no-confidence vote rules that benefit the incumbent party.”

Charts courtesy of Bloomberg

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