Spanish elections and the impact on the fixed income market

The June Brexit survey is clearly the most important market driver for non-core markets in the coming weeks, but Spanish elections are also an important market driver, certainly for Spain. Different scenarios are possible after the 26 June elections, leading to different market outturn.

The risk of having a political impasse after the elections is material in Spain as preliminary surveys point to the same set of results as at the 2015 December elections. The recently reached electoral agreement between Podemos and United Left should further weaken the position of PSOE. The risk of a no conclusive electoral outcome after the elections is real, bringing again political uncertainty which will pressure Spanish yields. The formation of a government with a radical programme, with the reversal of structural reforms, would also trigger an important negative market reaction.

A clear majority outcome on the other hand, with a programme that doesn’t reverse structural reforms initiated, would be very supportive for Spanish government spreads. Spain already made important fiscal and economic efforts and a government that would continue on this path would be seen favorably by markets. So far the negative market impact of having no government has been limited thanks to the ECB’s QE programme and will probably contain any major movement in government yields. But medium term political risk will increasingly matter for Spanish fixed income markets, certainly once the ECB starts discussing a tapering strategy.

Worst case scenario

The scenario that would pressure Spanish yields the most is the formation of a government with a radical programme that would revert structural reforms. Financial markets clearly prefer a scenario that will limit the risk of further fiscal slippage and the risk of the Spanish government dismantling some of the structural reforms (labour market reforms) decided over the past years.

A scenario of political impasse would also lead to a negative market reaction. A political impasse would nevertheless pressure main parties to form a government or not vote against the government formed (even a minority one), as there would be no political incentive for the biggest parties to go to the polls for a third time. If a negative election outcome is combined with a Brexit scenario in the UK, nervousness surrounding Spanish assets would be even more important.

Buying or selling Spanish debt?

Since February we started to take a more prudent stance towards non-core sovereign markets in general. Also on Spain we are more defensive now, as we think both the Brexit survey and Spanish elections could bring volatility and pressure on Spanish sovereign bonds in the short term due to the important uncertainty related to these events.

A marked upturn in Spanish yields in front or on the back of these events could be a trigger to increase our exposure but it will depend on the outcome of these political events. For example in case of a Brexit, investors in general would adopt a more prudent stance towards non-core countries while foreign investors could question mark their investments in Euro sovereign non-core debt. This would clearly weight on Spanish yields. In such environment, the reaction of the ECB will be key in reassessing our position.

In the short term the electoral result in Spain will clearly drive volatility on Spanish spreads. Further out, the ongoing QE programme will continue to be a powerful buffer in 2016 and for the beginning of 2017. It will however not be sufficient medium term if Spain doesn’t continue to resolve its structural issues: important unemployment, particularly for youth and the still important fiscal deficit. Indeed we don’t think Spain is immune to prolonged political uncertainty, even more if this is combined in 2017 with less support from the ECB.