Spain and Friday's Employment Report: A connection

In the last several days, Spain has surpassed Portugal as the next most vulnerable country in the Eurozone, stepping into the eye of the fiscal storm that is sweeping the bloc.

This development, on the face of it, is somewhat counter-intuitive, as Spain's total debt stands at a relatively benign 55% of its GDP, making it a rarity within the Eurozone as a country that is still in compliance with the requirement that such a ratio not exceed 60% of GDP. However, that ratio is rising quickly for Spain and, given the large current and anticipated budget deficits over the next couple of years, is expected to approach 80% of its GDP by 2013.

Still, even such prospect would not be particularly ominous, if it weren't for two highly disturbing characteristics of the Spain situation. First, the reluctance of the Spanish government to implement so far aggressive fiscal austerity measures to convey a reassuring message to global financial markets. This is the direct result of the country's extremely limited room for maneuver in the midst of the current crisis, given an already exorbitantly high unemployment rate of over 20%. Imposing a credible fiscal austerity package would send the unemployment rate sharply higher, with potentially cataclysmic consequences of social unrest. Second, the dramatic spike in Spain's borrowing costs in recent days, raises the specter of the country finding itself soon unable to access capital markets at an acceptable cost and approaching the downhill path that Greece was forced to take.

Spain may be at the threshold of another downgrade by the ratings agencies, which could actually come as early as Friday, adding more fuel to the already raging fire in the Eurozone's sovereign debt crisis. It is after all the fourth biggest economy in the Eurozone, accounting for approximately 12% of its output. Spain is not Greece and the entire fiscal crisis in the Eurozone may well be entering a new phase, if Spain finds itself effectively shut out of sovereign bond market financing.

All of this brings us squarely to Friday's employment report in the U.S.

Depending on the headlines on the Spain (and, to a somewhat lesser degree, Portugal) debt front by Friday, the U.S. Treasury market's response to April's nonfarm payroll data may deviate appreciably from the more "traditional" one. This means that the typically adverse reaction to a potentially above-consensus, "ex-census", payroll number may be mitigated by any negative developments on Spain's debt status. A deteriorating situation in Spain may well keep European sovereign bond and equity markets on the defensive, providing a bid for Treasuries that can overrun, or moderate, the natural instincts of the market to sell off on a strong employment report.

If the payroll report is underwhelming, as hinted at by the ADP number today (which, itself though, needs to be viewed somewhat cautiously, given its generally poor correlation with nonfarm payrolls) and Spain continues to slide over the next 48 hours, then the U.S. Treasury market may be set up for a potent rally, breaking through the lower end of its yield range since the beginning of the year.

Anthony Karydakis