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The markets took the lead from bond markets today and a broad-based sell off in risk occurred. Spanish 10-year bond yields reached a fresh euro-era high above 6.7% this morning. There is an air of inevitability about Spain, similar to what happened with Ireland and Portugal, when the rise in their bond yields seemed unstoppable. Without money to support Spain from the ECB or EU then it's hard to see what could stop Spanish yields from surging to 7% or higher, especially if they continue rising at their current pace.

Intense stress in Spain's bond market


Also of concern is the sharp drop in the spread between 10-year debt and 2-year debt, suggesting that Spanish debt with shorter maturities is coming under more downward pressure than longer-term debt. This suggests that investors are concerned about their ability to get their money back from Spain in the short term. Below is the 10-year yield - 2-year yield spread which has narrowed sharply in the last couple of days and indicates dangerous levels of stress in Spain's bond markets.


Source: Bloomberg and


The cost to insure Spanish debt against default hit a record, as did the spread between Spanish and German yields. But this time Spain's path to bailout territory could be more treacherous for risky assets then it was for Portugal or Ireland. Greece has already re-negotiated its debt held by private sector bond holders, if Spain gets a bailout it will come with strict conditions that could mean haircuts for its bond holders. This could lead to people pulling their money out of Spanish assets all at the same time, and it could even infect Italy. Its bond yields have also rise sharply today after an auction of 5 and 10-year debt earlier saw Rome have to pay much higher yields compared with auctions last month.

The European Commission is not Germany

Economic data is on the back burner so far today, with the focus being Spain. The PM Rajoy said earlier that Spain needs EU assistance with debt sustainability; this sounds like a bailout by the back door to me. However, his plea to EU and ECB authorities may have been triggered by reports in today's FT that the ECB would not sanction Spain using government debt to re-capitalise very bad bank Bankia by using this debt as collateral to secure financing from the ECB.

Cutting to the chase: the situation in Spain is getting ugly, a bailout could cost upwards of EU 380 bn, and we don't even know if Germany is willing to provide this sort of cash, especially since it seems unlikely that Greece and Ireland will be able to return to the capital markets next year for financing. The closest thing we have had to official support for Spain is a statement from the European Commission that it would allow the ESM rescue fund to re-capitalize banks. But the markets are unlikely to be placated that quickly - it wants to hear those words come directly from Merkel before it is willing to stage a relief rally. The chances are increasing that an emergency EU summit will be called imminently.

Market moves:


So go bond yields, so go other asset classes. The euro took the cue early on in the London Session from Spanish bond yields, and after recovering back to 1.25 it was sold off sharply. 1.2450 ended up being a flimsy level of support that the bears easily broke through. The problem is for those not already in the short euro trade are: have you missed the boat? Well a good way to look at it is that if gains in EURUSD are potentially capped around 1.25 (prior support now good resistance), then even if there is a pullback your losses could be fairly minimal. Yet, with the problem in Spain still unresolved and getting more and more critical as each day passes it looks like there may be more downside in the single currency. Below 1.2470 things get ugly, and we could see back towards the 1.2170 lows from 2010 and then the key 1.20 level.

However, the markets remain incredible sensitive to both positive and negative headlines. The statement from the European Commission caused a bounce in risk to 1.2450 in EURUSD. However, this may be short lived, as we said we need to hear this from Germany before we get too excited However, the bounce may have provided a good entry for a fresh EURUSD short for the most nimble traders out there.

The other big mover is USDJPY. It dipped as low as 70.01 earlier and looks extremely vulnerable. The yen is gaining from two sources: 1, the risk aversion that is fuelling safe haven flows into the Japanese currency and 2, news from the BOJ that it may not be willing to do more stimuli to boost the economy. However, below 79.00 might pique the Japanese government's attention and we could start getting some verbal threats of intervention if there is excess volatility in the FX market. Below 79.00 the next major support level of note is 78.50 then 77.20 - the 100-week moving average.

As we have said, the bond market is leading the way; if we see pressure ease off Spanish bonds then we could see a broader based relief rally.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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