Spain will pay dearly for longer-term debt on Thursday when it auctions a 10-year bond for only the second time this year to markets spooked by fears it will miss deficit targets and fail to restart growth.
The benchmark 10-year bond peeped above 6 percent on Monday for the first time since the end of November, sparking concern it could soon become unsustainable for the government to refinance itself, though pressure on the paper has since eased.
The Treasury aims to raise up to 2.5 billion euros ($3.3 billion) between the auction of a bond maturing October 31, 2014, with a 3.3 percent coupon and the benchmark, which comes due January 31, 2022 and holds a 5.85 percent coupon.
The relatively small auction - and the fact the Treasury has already raised 47 percent of its gross issuance target for this year after taking advantage of two European Central Bank credit lines - means demand is likely to be high.
However, after Spanish borrowing costs jumped at a bond auction on April 4 and a T-bill auction on Tuesday, yields on Thursday will also climb as sentiment wavers.
The momentous fallout initiated by Spain over recent weeks has served as a jarring reminder that its underlying fiscal and economic shortfalls threaten to pull it off track, strategist at 4Cast Jo Tomkins said.
Confidence has been knocked and it will take the government some time to break the negative feedback loop. While a bailout is not in our central scenario it is hard to deny that PM Rajoy's cabinet faces a mammoth task (meeting the 2012, 2013 deficit targets).
Spain entered its second recession since 2009 in the first quarter after more than four years of contraction or minimal growth following a burst property bubble and more than a decade of strong expansion.
The economic slump turned a budget surplus in to one of the euro zone's highest deficits in just two years and the government has been struggling to convince markets it can rein in the shortfall ever since.
Debt costs for the Spanish Treasury have jumped since Prime Minister Mariano Rajoy ripped up a deficit target previously agreed with Spain's European partners. While he reached an accord on the shortfall for this year and next, many economists say the target is not realistic.
Spain must cut a deficit which was 8.5 percent of gross domestic product in 2011 to 5.3 percent of GDP this year and 3 percent in 2013. The International Monetary Fund said on Tuesday it didn't expect the 3 percent deficit target to be achievable by at least 2018.
The 2-year bond, which was last sold at a primary auction October 6 for an average yield of 3.495 percent, was trading on the secondary market, considered a reasonable estimate for yields at auction, at about 3.5 percent on Wednesday.
The 10-year bond, last sold via syndicate in February at a yield of 5.403 percent and sold at auction January 19 for the same yield, was trading in the secondary market at around 5.8 percent on Wednesday.
While costs were likely to rise for the Spanish government on Thursday, the relatively small scale of the sale meant demand for the paper would be stronger than the April 4 auction.
The context is somewhat different from the last auction which was influenced in part by the holiday period. The relatively small auction size should help the market digest the supply, Citi said in note.
($1 = 0.7610 euros)
(Reporting By Paul Day; Editing by Peter Graff)