YESTERDAY MAY just have been the day the bond markets lost confidence in Spain. Madrid’s 10-year borrowing costs soared to their highest levels of the euro era, rising to as much as 7.57 per cent and, according to investors, making a full international rescue all but certain.

The relentless rise in Spanish bond yields, and especially those on short-dated debt, is all the more worrying, given European finance ministers last Friday approved a €100 billion bailout of Spain’s banks, with the first €30 billion instalment due by the end of the month.

The good news had been priced in. Instead, investors have been unnerved by a string of headlines pointing to deeper economic malaise and evidence that the countrys indebted regional administrations need help.

Valencia’s request for aid from the central government is expected to be followed by similar emergency appeals, from Catalonia for example, a region with an economy the size of Portugal. The Bank of Spain yesterday said the country was expected to remain in recession until 2014, adding to the headwinds as Madrid struggled to retain access to the markets.

“The regional problem just adds to the sense that things are out of control in Spain,” says John Stopford, co-head of fixed income and currencies at Investec Asset Management. Spain’s stock market fell as much as 5.5 per cent yesterday, after falling almost 6 per cent on Friday, paring losses after a short-selling ban was imposed.

“When we’ve got to these levels before, it’s often been a precursor to policymakers acting somehow. There’s a big risk that Spain spirals out of control,” says Alan Wilde, head of fixed income and currencies at Barings.

While the jump in benchmark 10-year bond yields grabbed most of the attention, the more ominous move was in shorter-dated bonds.

Yields on Spain’s two-year debt climbed another 78 basis points yesterday, the biggest one-day jump since the euro-zone crisis erupted more than two years ago, to a euro-era high of 6.54 per cent.

In bond market parlance, the yield curve is “flattening” and close to inverting, as short-term bond yields come close to exceeding those on longer-term bonds. And that has fearful implications for Spain. One reason Madrid has been able to continue funding itself even as 10-year yields have risen to levels regarded as unsustainable is that it has been selling shorter-term bonds and bills at lower yields. That has helped keep the cost of its interest rate burden under control. The sharp jump in shorter-term borrowing costs puts that in jeopardy.

Moreover, a disappointing auction of two- and five-year Spanish bonds late last week cast doubts over the ability of local banks to keep the government funded in the coming months.

Spain will face plenty of tests of its access to capital markets over the rest of the year, even after progress on refinancing its debts in the first half of 2012. Madrid still has to sell about €36 billion of bonds this year. Next year is likely to be equally challenging.

Should short-term yields continue to rise, and more regional governments appeal to Madrid for help, it is hard to see how Spain could maintain access without, for example, the European Central Bank or the euro zone rescue funds buying its debt. As Philippe Meyer of Société Générale puts it: “The drumbeat of the market for a full bailout is getting louder.”

For now, yields on Spanish bills, debts that mature in one year or less, remain relatively subdued. But few believe Madrid can finance itself for long in the very short-term market.

“If yields stay at these levels then Spain will find it very difficult to fund itself,” warns Pavan Wadhwa, global head of interest rate strategy at JP Morgan. “There’s no such thing as a partial bailout, and it has become increasingly clear . . . Spain will need a full sovereign bailout.” – (Copyright The Financial Times Limited 2012)