Spanish Woes Continue To Deepen; Turmoil Spreads To Italy

(WSJ) The euro-zone debt crisis deepened Tuesday as a sharp rise in Spanish government bond yields to their highest levels since the inception of the euro fanned speculation that the country might need a bailout of its own, just days after Spain sought a support package for its beleaguered banking system.

The market turmoil also spread to Italy, the euro-zone's third largest economy, where bond yields leapt higher ahead of a crucial bond sale later this week and weekend elections in Greece that could decide the country's fate in the common-currency region.

The deepening gloom surrounding Spain's credit-worthiness could have grave implications. A sovereign bailout for Spain will severely test the firepower of the euro area's rescue funds, hardly leaving any money in the pot if Italy were to be shut out of bond markets.

"It is quite likely that Spain needs a full bailout in the near future although policymakers will try all possible options to avoid this outcome, including a revival of bond purchases by the ECB as well as another three-year liquidity operation," said Pavan Wadhwa, global head of interest rate strategy at JPMorgan.

"The concern is that the more peripheral debt the official sector holds, worries over subordination mean that the private sector will be less willing to lend to these countries," he said.

Investor appetite for Spanish debt has waned in recent months with foreign investors remaining firmly on the sidelines as the sovereign's borrowing costs move ever closer to levels seen as unsustainable by the market. Fears that private bondholders will fall behind official creditors in the pecking order has served to undermine sentiment further and snuffed out any optimism following the bank rescue package.

"The bottom line is that the (Spanish) bank bailout is a sovereign liability and will increase government debt by around 10% of GDP," analysts at Citigroup said in a note to customers.

"Furthermore, if the funds come from the ESM [European Stability Mechanism] this will likely subordinate existing bond holders."

Spain has sought a bailout package of up to 100 billion euros ($125 billion) to shore up its ailing banking sector. Unlike other euro-zone rescue deals, Spain is still expected to come to the government bond market for its funding requirements.

"The feeling in the market is that the (Spanish) banking package is too little, too late," noted one trader before adding "I'd say there is a 50% chance that Spain needs a bailout of its own and Italy's not far behind either."

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