The yield gap between short-term Spanish and German bonds held near its widest point in five months on Friday, as Spain braced itself for its most uncertain election in four decades. Sunday's parliamentary election is expected to mark a shift from decades of stable two-party politics to a new era of coalition.
-- German two-year yields at lowest since December 3 ECB meeting
Prime Minister Mariano Rajoy's conservative ruling People's Party (PP) is expected to win but fall well short of an absolute majority, and there is no guarantee he will be in a position to form a stable government. "Investors are not keen to take positions ahead of the election," said Mathias van der Jeugt, rate strategist at KBC. The gap between yields on two-year Spanish bonds and their German counterparts was at 46 basis points, hovering close to its widest in five months.
Spain's 10-year bond yield fell 4 bps to 1.70 percent in line with their euro zone peers. Analysts say a fragmented political landscape comes not only with risks, but with an opportunity to fix long-standing issues. "I don't think Spain is about to fall off a cliff," said Societe Generale strategist Ciaran O'Hagan. "Given the legacy of corruption, having the oversight of one party over the other is advantageous."
Rajoy said on Wednesday he would consider a political pact to assure a stable government over the next term but opposition parties have said they would not enter a coalition with the PP. Still, analysts said any risk from the vote was mitigated by the fact that any new government in the euro zone, regardless of political colour, would still need to comply with requirements from Brussels - as Greece has shown this year.
In addition, the European Central Bank's 60 billion euro monthly bond-buying programme provides a strong buffer. Portuguese 10-year bond yields, are down 40 bps from four-month highs hit in early November because of the instability that followed an inconclusive election.
"The Spanish population know what an extreme vote could bring. They have Greece as an example," said Eric Vanraes, fixed income portfolio manager at EI Sturdza Investment Funds. "But for the bond market it doesn't matter. Whatever the result of the elections, (ECB chief) Mario Draghi said 'whatever it takes'. In illiquid markets, it's a good idea to hold bonds that are on Mario Draghi's shopping list."