Fundamentals Q'n: Deficit Targets and Relationships to Bonds and Currency Pairs

Interesting situation arose on Frieday, which I am assuming is based on market and investor perception of EU lack of political coherence or lack of faith in leadership collaboration, but would be interested to hear thoughts on this apparent markett anomaly…

Friday 2nd Feb 2012 announcement by Spanish PM at the end of negotiations of intention to achieve a 5.8% deficit to GDP target. Agreed target with EU prior of 4.4%, however. This higher deficit to gross domestic product target for the year led to downturn in EURUSD. Commentator: “much more realistic” than the previously proposed 4.4% level by Brussels.

Nevertheless, resulted in: Drop in EURUSD and Spanish bonds “fell”. So this denotes lack of market confidence despite what at least one commentator describes as greater realism!? OK he /she is only one person, but it would seem he or she is informed…

Second question: This announcement led to a pushing of the yield on the 10-year Spanish government bond up 5 basis points to 4.90%. (“Spanish bonds rallied earlier this week after European banks snapped up hundreds of billions of euros in cheap, three-year loans at the European Central Bank’s long-term refinancing operation on Wednesday.” - Marketwatch).

Does this all mean that investors jumped in on an opportunity offered by the ECB to ‘sell soverign debt via bonds’, which would be impacted by the Spanish announcement somehow? If so, what is the connection?

I understand this much: ECB wanted liquidity, to shore up their coffers; the market obliged and bought on the expectation of good returns on those bonds 3 years later. Meantime, those banks and investors who bought for the longer term were to benefit even more because of the cumulative earning effect over 10 years, I presume.

If Spain sets a higher target for itself to reduce its deficit, this means greater austerity shorter term; does the market believe that austerity => stunted growth and thus markets believe that repayment by Spain at the end of the three year (or more) end of term will be unfeasible? Is this because of potential raised interest rates in the interim, plus slowed revenues due to austerity, means less sovereign capacity to buy back the bonds. So the bonds become less attractive to investors who do not have the faith in Spain’s capacity to thrive?

If I sound like I have some clue, please don’t assume that I understand too much in your replies. I find fundamentals mind-blowing and it’s a jigsaw I’m still sorting out all the pieces on! You are bound to be pretty geeky to answer this one, so please be gentle and I don’t mind if you spell it out like I’m in kindergarten… (I just left there recently in the School of Pipsology!) :31: Cheers all.