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MADRID (Reuters) - Spain's borrowing costs are likely to stay high on Tuesday when it tests investor appetite for its debt for the first time since announcing more austerity last week, suggesting markets remain unconvinced it can avoid a European bailout.
Prime Minister Mariano Rajoy unveiled a package of savings and tax hikes worth 65 billion euros (51.18 billion pounds) over the next two and a half years, in a bid to demonstrate that Madrid can control its finances. But market doubts have kept its debt costs elevated.
Yields on the short-term debt, using secondary market pricing as a guideline, are likely to be sharply lower than the last time it was sold at auction in June - but still near euro-era highs.
The yield on the 12-month bill was around 3.5 percent in secondary markets on Monday, down from an average of 5.074 percent last month, which was its highest in 15 years.
On the 18-month bill the yield was around 4.0 percent compared with an average 5.107 percent at auction in June, right after Spain sought an up to 100 billion euro rescue plan for its ailing banks that fuelled fears it could soon seek a full-scale state bailout.
"There are still massive risks that Spain will need a sovereign bailout," said Jo Tomkins, analyst at consultancy 4Cast.
"It's got to a point where it's not just about austerity. People question whether Spain will be able to grow its way out of recession and produce revenue," she said.
However, she expected the auctions to go well even if investors demand a stiff premium, forcing the Treasury to pay more than expected.
Domestic banks are expected to provide the bulk of the 2.5 billion to 3.5 billion euros it aims to sell, although analysts and market makers said they could be reaching a limit for absorbing sovereign bonds.
Spain is scrambling to avoid a full sovereign bailout like Portugal or Ireland as it fights to deflate one of the euro zone's highest public deficits, tries to control its highly indebted regions' finances and struggles to prop up its banks while slipping into a deep recession.
Analysts fear the austerity measures could backfire on the government, driving the country into a deeper recession, which would in turn reduce tax revenues and make it harder for it to hit deficit targets.
The short-term debt sale also comes before key auctions of up to 3 billion euros of medium- and longer-dated bonds from the Treasury on Thursday, which will also likely show no sign of easing up in the country's borrowing costs.
On Thursday the Treasury will return to markets to sell bonds maturing in 2014, 2017, and 2019.
Yields on Spanish 10-year debt dipped briefly last week after Rajoy outlined the new measures, but they have since risen around 15 basis points, leaving them close to 7 percent, a level seen as unsustainable in the medium term.
The Treasury has sold 65 percent of its planned medium- and long-term debt issuance for the year, having raced ahead of schedule at the start of the year when banks snapped up debt with cheap European Central Bank liquidity.
A higher deficit target for 2012, as agreed with the European Union, as well as a new mechanism to ease the regions' funding troubles, will however force the Treasury to raise more money from investors than initially anticipated.
Editing by Julien Toyer and Hugh Lawson