Rajoy's Strong Arm Tactics in Catalonia Create a Slow Burn for Spanish Bonds

(Bloomberg Gadfly) -- The market reaction to Sunday's Catalonia independence referendum may look muted but the longer-term impact is more worrying. Prime Minister Mariano Rajoy has turned a low probability event into a persistent problem. 

This secession issue may prevent the minority Spanish government from getting anything done, potentially stifling Spain's impressive economic recovery. The 2018 budget process has already been put on hold after Rajoy was unable to secure enough votes last week.

There are already knock-on effects. S&P Global Ratings affirmed Spain's long-term credit rating at BBB+ with a positive outlook after the Friday market close. There had been expectations of an upgrade to A-, but S&P disappointed this, citing the referendum as a drag on growth.

Initial Spanish market reaction wasn't

Major

But the bonds are hardly pricing in disaster. Spanish government bonds are 6 basis points higher in yield from Friday's close but just 4 basis points wider in spread to Germany. Hardly a major reaction in what is already a higher yield session led by U.S. Treasuries in Asia. There has been a similar reaction in equities, with the IBEX 35 down more than 1 percent, whereas most European bourses have opened up.

Both come in a backdrop of relative weakness. Spanish debt has been a laggard among euro peripherals since August as the Catalan political issues erupted. The IBEX has steadily underperformed the EuroStoxx 50 over the past month.

Though the European Central Bank and its QE bond buying program can smooth things out, the trend of Spanish markets underperforming may well persist. Rajoy's handling of the situation has turned a minor issue into a major political drag that can affect the whole economy -- as Bloomberg View's Therese Raphael wrote Monday, his government has lost legitimacy in the eyes of many. The minority parties he relies upon in parliament will surely be less disposed to help him with any legislative program. 

The clearest barometer will be the progress of this week's two bond auctions. Spain plans to sell a new five-year note and will also increase the size of an existing 12-year issue. Given that the markets are already widening, expect the yield to be higher by the time the sales take place. It doesn't look now like any of the parties are going to back down in the short term, and until they do the markets will bear the brunt of Rajoy's rough handling of the situation. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story: Marcus Ashworth in London at mashworth4@bloomberg.net.

To contact the editor responsible for this story: Jennifer Ryan at jryan13@bloomberg.net.