Between markedly higher yields at the Spanish T-Bill auction (which has been spun as 'successful' due to demand?), a step in the right direction for ESM (from the German courts), and a dismal ZEW survey, finding a reason for the outperformance of Spanish bonds this morning - where 10Y bond spreads have rallied around 20bps (but remains above 7% yield) is a guess at best. However, while this fulcrum security is encouraging risk-on (reality-off) around the world, we suspect in a sorry-to-disappoint way, that the marginal bid on Spanish bonds is in fact once again the CDS-bond arbitrage trading community. Since last Monday's open (post Spanish bailout), the spread between the Spanish bonds and CDS has widened to over 100bps (from around 0bps). This underperformance of bonds relative to CDS has again and again provided an arbitrage opportunity at around these levels and given the thinness of the Spanish bond market, we suspect some renewed arbs (trying to lock in 80-100bps of 'risk-free' carry and convergence) were the real drivers of Spain's strength. So, be careful in believing what you are seeing as sometimes the whole picture is obscured when you don't know where to look - as 10Y Spanish bonds are 20bps tighter while 10Y CDS are 12bps wider. And once the spread between CDS and bonds is gone then away goes that marginal bid for bonds - so now you know what to watch for a signal of pending weakness in Spanish debt.
The spread between Spanish bonds and Spain CDS (negative means that Bonds are trading wider/cheaper than CDS; and a falling chart means bonds are underperforming CDS markets) has fallen in the last week post-Spanish bailout as bonds underperformed. Again and again, when the basis gets to around 100bps, we see the arbitrageurs step in and pick up the scraps...
and close-up the last week has seen the 'basis' - CDS spread minus Bond spread (not asset-swapped for simplicity here) - compress from a 'fair' level near 0bps to more than 100bps. This 100bps can be arbitraged by buying the bonds and then buying protection in CDS markets - thus providing a marginal bid for Spanish bonds in a market dearth of natural buyers (so sometimes those horrible hedge funds have a use eh?)
and nowhere is this more clear than the difference in price action in the last two days between CDS (lower pane) and Bond Yields/Spread (upper panes)...
The bottom-line is that as the basis reverts back towards 0-20bps then the demand for Spanish bonds at the margin from basis traders will evaporate (and in the meantime we see the local-law bonds continue to underperform non-local-law bonds).
As an addenda, please please please remember that the only way to judge European debt auctions is yield since demand is entirely biased by either a captive banking system or implict ECB support. So bid-to-cover is now practically useless as any indication of 'strength' especially when you simply consider "how much would you bid for Spanish bonds at a yield of 10%, 20%? 40%?"