In our view, the Spanish banking system is in need of wholesale recapitalisation to deal with the sizeable losses in the country’s property market. This will likely include a bad bank provision.  Before that happens, the ECB’s open market operations will mainly buy time in the form of liquidity as well as provide banks with money to exchange bad loans for lending to the government. However, with Spanish government bond yields already breaking out of range 2 months after the last ECB auction, the imperative to find a more sustainable solution imposes itself.

Essentially, the ECB’s open market operations and direct government bond purchases are substitutes in so far as they achieve the same purpose in the periphery. The main question is now whether the ECB is ready to step in with either a new LTRO auction or direct purchases through the SMP only 2 months after it effectively increased its balance sheet by €1 trillion.

Before any of this in our view, the ECB is likely to act with additional rate cuts, but the pressure is mounting. Spanish Prime Minister Rajoy recently affirmed that Spain must do what it can to reduce its deficit, but cracks have emerged in the discourse after Deputy Minister in the Ministry of Economy Jaime Garcia-Legaz called for the ECB to buy Spanish government bonds directly.

It is not clear what kind of EU financing vehicle that would be able to recapitalise the Spanish banking system directly and whether it would be able to supply the Spanish sovereign with capital to do it itself.