December 21, 2017 / 12:05 PM / a year ago

UPDATE 2-Spain's bond yields fall as Catalonia votes in key election

* Catalonia holds regional election

* Madrid hopes vote will end region’s independence bid

* Spanish bond yields nudge lower

* German bonds yields hold near highs

* Slight out-performance by Italy & Portugal

* Euro zone periphery govt bond yields (Updates prices)

By Fanny Potkin and Dhara Ranasinghe

LONDON, Dec 20 (Reuters) - The premium investors demand for holding Spanish bonds over top-rated German peers fell to its lowest in almost three months on Thursday as Catalonia held an election that Madrid hopes will end the wealthy region’s independence bid.

After two days of heavy selling in U.S. and European bond markets, euro zone bond yields held near multi-week highs as the U.S. House of Representatives approved a sweeping overhaul of the U.S. tax code.

Spain’s government hopes that the Catalan election will strip pro-independence parties of their control of the regional parliament and end their campaign to force a split with Spain.

But while final polls showed separatist and unionist parties running neck-and-neck, a pro-independence government — majority or minority — remains possible.

A separatist majority would further dampen investors’ confidence in Catalonia, which has an economy larger than that of Portugal and is the main driver of Spain’s economic growth. However, pro-independence leaders have backed away from demands for unilateral secession.

“It (the election) cannot be ignored going into year-end,” said Orlando Green, European fixed income strategist at Credit Agricole in London. “But the secession movement has been significantly diminished and would need a decisive move to revive it.”

Spain’s 10-year borrowing costs fell 2 basis points to 1.46 percent, down more than 30 basis points from highs seen in the wake of October’s banned independence referendum.

That narrowed the gap over German peers to around 105 basis points, its tightest in almost three months.

Analysts at Mizuho said markets were now inclined to treat Catalonia as a domestic issue.

“Our view is that buying ahead of the election is acceptable risk reward, given that a surprise win for separatists may simply lead to negotiations for greater autonomy,” they said in a note.

“If the polls are right, that separatists fail to gain a majority, then the Spanish economy can resume its recovery and the market should revert to pricing Spain gaining semi-core status in the forwards.”

Spain’s IBEX stock index made up early falls and nudged into positive territory, putting in a slight outperformance against the euro zone’s other major bourses.

Still, the yield on Catalonia’s outstanding bonds maturing in February 2020 pulled off recent lows and was up 17 bps since Monday at 1.81 percent. The spread over the comparable Spanish government bond widened 7 basis points over that period to 206 bps.

Portuguese and Italian bond yields traded 4 bps lower, outperforming Spain on the day.

Voting stations in Catalonia close at 1900 GMT. The election is expected to draw a record turnout.

Most other euro zone bonds were flat to a touch lower on the day, holding near recent highs. Euro zone bond markets have been hit hard in the past two sessions, triggered by a rise in German borrowing plans for 2016, strong U.S. economic data, and the completion of a U.S. tax overhaul.

Reporting by Fanny Potkin, Dhara Ranasinghe, and Abhinav Ramnarayan; Editing by Alison Williams/Jeremy Gaunt

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