Spread Between Spanish and German Bonds Widen to Record High

As Europe continues to reel from the deepening fiscal crisis in Greece and Italy, more fears are rising about the state of Spain’s finances.

The spread between Spanish and German 10-year bonds reached a new record high on Monday, suggesting that the market has little or no faith in Madrid’s ability to tackle the country’s debt and stabilize its stretched finances.

The yield on Spain’s 10-year sovereign bonds rose just above the dangerous six percent level from 5.85 percent on Friday. The spread between these securities and the German bund, which are considered very safe investments, widened to more than 422 basis points at one point-- an all-time high.

Spanish bonds hadn't breached the six percent barrier since August, although the spread relative to German bonds was lower back then.

Similarly, 10-year bonds in Italy --which is in the process of forming a new interim government following the passage of an austerity program--saw their yield climbing to more than 6.60 percent on Monday trading. Last week, Italian yields soared well above 7 percent.

Phyllis Reed, head of fixed-income research at Kleinwort Benson Bank in London, told Bloomberg: There's a high probability of Spain following Italy. In the very short term, the trigger is just the fact that we're getting close to the edge of the abyss with the euro.

Meanwhile, the bad news for Spanish bonds comes a few days before an election that will likely be seen as a referendum for the Socialist government’s stern austerity program.

The markets' attitude towards Spain is quite sanguine compared to Italy at the moment, but we think that this could potentially change in the coming months, if not weeks, Stephane Deo, chief European economist at UBS AG in London, wrote in note.

He added that the market is deeply concerned about a recession in Spain as well as the potential huge costs of a bank bailout.

As in Italy, Spain is hampered by weak economic growth.

The European Commission reported that Spain’s budget deficit is expected to amount to 6.6 percent of GDP this year, well above its 6 percent target. In the absence of effective measures by the Madrid government, the deficit will reach 5.9 percent next year, again, above a 4.4 percent target.

Meanwhile the economy will only eke out a 0.7 percent gain this year and next--well below the government's targets of 1.3 percent this year and 2.3 percent next year.

Nick Firoozye, head of interest-rate strategy at Nomura International Plc in London, told Bloomberg: The risks are that further austerity will hurt growth, coupled with the global downturn, and that that makes the deficit climb.”