Spain passed a key test on Thursday by easily selling 3.1 billion euros of debt at yields well below recent peaks despite investor doubts that the European Central Bank will act to help struggling euro zone economies at its meeting later in the day.
Although the Treasury was forced to pay the second highest yield on its 10-year paper since the launch of the euro in 1999, analysts said the auction was solid in the current context. The cost of borrowing over 10 years was 6.65 percent, nearly a full percentage point below the 7.64 percent peak n the secondary market last week.
The results lifted market sentiment, with the premium which investors pay to hold Spanish over German debt falling after the auction.
Spanish bond yields, which had hit euro-era highs due to the possibility that Madrid would have to be bailed out, fell last week after President Mario Draghi said the ECB would do whatever it takes to save the common currency, within its mandate.
In the same spirit, Italian borrowing costs also fell at an auction on Monday, suggesting that Draghi has at the very least talked yields down.
But concerns that the ECB will now fail to meet the market's expectations when Draghi announces decisions of the Governing Council's monthly meeting at 1230 GMT sent them up again in the last two days.
"The auctions were good, with better demand at the shorter maturities which looks to me like the auctions were driven by more short-covering demand," said Peter Chatwell, rate strategist at Credit Agricole in London.
"Certainly there is still a lot of doubt whether the ECB has the mandate to do anything which structurally tightens Spanish or Italian spreads."
Sources have told Reuters that bold action - such as the ECB resuming controversial purchases of government debt issued by the most troubled euro zone economies to curb their borrowing costs - is at least five weeks away. However, Draghi may offer some clues on what is in the offing.
On Thursday, Spain sold 3.1 billion euros of bonds, beating its target of 2 to 3 billion euros, though it paid higher rates than the last time the bonds were sold at a primary auction.
The Treasury raised 1 billion euros of the longer-dated, benchmark bond, due January 31, 2022, at an average yield of just below 6.65 percent compared to 6.43 percent when it was last sold in the primary market on July 5. The yield in the secondary market had reached 7.639 on July 24, before Draghi spoke last week.
Demand was lower than the previous auction, with the bid-to-cover ratio at 2.4 compared to 3.2 a month earlier.
A bond due July 30, 2014 sold 1.1 billion euros at a yield of 4.77 percent and bid-to-cover ratio of 3.0. The same bond was last sold at a primary auction in March, 2011, at an average yield of 3.59 percent.
A bond maturing October 31, 2016 sold at a yield of 5.97 percent, after just below 5.54 percent July 5. The Treasury sold 1 billion euros of the paper which was 2.7 times subscribed compared to 2.6 times last month.
For a graphic on Spanish debt average maturity and interest rate, please double click on http://link.reuters.com/qyq69s
For a graphic on Spanish government bond turnover, please double click on http://link.reuters.com/wam69s
For a graphic on Spanish & Italian bondholders, please double click on http://link.reuters.com/kux87s
(Editing by Jeremy Gaunt.)