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Just when we thought that Italy is next on the euro zone’s hot seat, Spain stole the spotlight and caught investors’ attention.

Market players are now focusing on Spain because its 10-year government bond yield has rapidly risen from 4.9% at the end of February to 5.4% last Friday. For those who missed my post on government bond yields, this basically means that investors are losing confidence in Spain’s economic prospects.

By contrast, Italy’s 10-year bond yields have remained relatively stable. If you remember, just a few months ago Italy was the top candidate to follow Portugal, Ireland, and Greece in asking the EU for bailout money. This is probably why traders took notice when Spain’s borrowing costs went ABOVE Italy’s two weeks ago.

What has gotten market geeks worried?

The Spanish government took center stage a few days ago when it tried to revise its 2012 budget deficit forecasts from 4.4% of GDP to 5.8%.

That’s a lot higher than the EU’s mandated 3%! Prime Minister Mariano Rajoy eventually compromised at 5.3%, but the attempt has already alerted investors to the possibility that Spain might not meet its deficit targets.

Even Spain’s banks are causing headaches for European officials. Because of their ridonculous exposure to the sinking real estate sector, many are speculating that Spanish banks would soon need fresh capital in order to survive. And that’s even before the new austerity measures kick in!

Yup, you read that right. In order for the Spanish government to meet its new deficit targets, it would have to cough up an additional 35 billion EUR worth of savings on top of the 15 billion EUR tax rises and spending cuts already announced in December.

Will Spain meet its deficit targets?

Analysts are worrying that the Spanish economy could end up in a downward debt spiral where austerity measures choke economic growth, potentially translating into less tax revenue for the government and eventually lead to more spending cuts. With that said, I’m not surprised that the IMF is forecasting a 1.7% contraction in 2012, along with other marker players declaring Spain will be in its second recession since the 2008 financial crisis.

Before you hit the panic button though, you should know that the eurozone and Spanish officials aren’t just sitting in a corner eating churros and sipping hot chocolate. Spain’s Economic Minister Luis de Guindos reaffirmed the government’s commitment, saying that comparing Spain to Greece and other bailout-friendly countries is “total nonsense,” as Spain will stay on track to meet its 5.3% deficit targets.

The ECB’s long-term refinancing operation (LTRO) is also helping ease market fears, as it has provided the Spanish banks the opportunity to load up on capital and buy Spanish government bonds. In fact, it is estimated that Spain’s banks borrowed a total of 23.1 billion EUR in the ECB’s last LTRO. They say that at least one-third of those funds went to Spanish government bonds, which helped drive down the country’s borrowing costs.

Even if Spain does miss its deficit targets and default on its debts, it can always knock on the EU’s doors and ask for bailout money. Word on the street is that European officials are pushing for a combined rescue fund worth 700 billion EUR to provide liquidity for indebted counties like Italy or Spain in case they get blocked off the markets.

But that’s a bridge that we have yet to cross. Right now we should watch the newswires and our charts for any clues on risk sentiment in the eurozone. Spain’s 10-year government bond yields eased off their highs last Friday, but if concerns on the Spanish economy continue to escalate, then we just might see the euro inspire volatility in our favorite currency pairs!