Spanish bond yields at record high as Fitch downgrades 18 banks and financial contagion spreads to Italy

Spain’s borrowing costs soared to their highest levels since the introduction of the single currency in 1999 today, as any confidence investors might have taken from Madrid’s weekend pledge to seek a bailout for its toxic banking sector drained away.

Yields on the country’s 10 year bonds shot up to 6.8 per cent this afternoon as investors frantically dumped their holdings of Spanish debt, before falling back to 6.72 per cent.

The credit rating agency Fitch added fuel to the flames of alarm by downgrading 18 Spanish banks, following its downgrade of Madrid’s sovereign debt to BBB last month. Among the Spanish lenders cut were Bankia, CaixaBank, and Banco Popular Espanol, with Fitch blaming the weakening Spanish economy, which is forecast to contract by 1.7 per cent this year and to remain in recession well into next year.

Uncertainty over the Spanish bailout is one of the driving forces behind growing investor unease. A decision is yet to be taken over whether Spain will receive funds to rescue its banks from the temporary European Financial Stability Facility (EFSF) or from its permanent replacement, the European Stability Mechanism (ESM), which is due to come into force next month. If the ESM is used, existing holders of Spanish sovereign debt would find themselves pushed further down the queue of creditors in the event of a sovereign restructuring, acting as an incentive for investors to get out of Spanish debt now.

Germany and the Netherlands have indicated that they would prefer the funds to come from the ESM. A suggested compromise is for the funds to come from the EFSF and to then be transferred into the ESM, while keeping the same legal status to reassure existing private sector creditors. But this would need to be approved by all eurozone leaders.

Meanwhile, Spain’s financial contagion spread to Italian bonds today, with Rome’s borrowing costs spiking steeply, hitting 6.22 per cent at one stage in trading, before settling at 6.16 per cent. Italian 10 yields have not been this high since January.

The technocrat Italian prime minister, Mario Monti, lashed out at the Austrian finance minister, Maria Fekter, who, earlier this week, refused to rule out the possibility of Italy needing to seek its own bailout in due course. Mr Monti branded Ms Fekter’s comments “completely inappropriate”.

Italy has a deficit half the size of Spain’s and its banking sector is believed to be in much better condition. But the country is in a deeper recession, having contracted by 0.8 per cent in the first three months of the year and by 0.7 per cent in the preceding quarter.

The last time that Spanish borrowing costs were at yesterday’s levels was during last November’s panic, which prompted the European Central Bank (ECB) to begin its €1 trillion liquidity operation for the European banking system. The vice president of the ECB, Vitor Constancio, sounded relatively dovish yesterday, saying that the central bank is ready to act to stabilise the eurozone if necessary. “We stand ready to provide liquidity and we are ready to face whatever may occur” he said. But last week the ECB failed to cut interest rates from 1 per cent.

After many weeks of prevarication and denial, Spain announced on Saturday that it will apply to the European Union for a bailout of up to €100bn in order to recapitalise its banks, which have been pushed to the brink of insolvency by bad loans made to the country’s collapsed property sector. Spain has said it will not know how much support it will need until later this month when an independent audit of its domestic financial sector by consultants Roland Berger and Oliver Wyman is completed. The International Monetary Fund has estimated that the sector needs at least €40bn.

The Spanish government, led by prime minister Mariano Rajoy tried, unsuccessfully, to persuade its European partners to use the common bailout resources to rescue its banks directly, bypassing the state. But, instead, any eurozone bailout loans will now add to Spain’s sovereign debt pile, pushing the country’s total indebtedness to 90 per cent of GDP.