Irish and Spanish debt auctions attracted strong demand on Tuesday and allayed concerns about the pressure on costs of funding for euro zone countries saddled with high debt and poor growth.
Irish debt spreads fell from three-month highs and the cost of protecting against a sovereign default fell from 17-month peaks after Dublin hit the top of its 1.5 billion euros (1.2 billion pound) target range in spite of jitters over the escalating cost of cleaning up its banking sector.
Yields that Ireland's central bank governor has called "ridiculous" fell compared to a month ago, as did Spain's, helping the euro extend gains against the dollar and come off 7-week lows against the yen.
"Much better than the markets had expected, and there is some relief that Ireland was able to put away the bonds. So the euro is seeing a bit of a rebound," said Ian Stannard, senior currency strategist at BNP Paribas.
Concerns that Ireland, Spain and other euro zone "peripheral" borrowers will struggle to dig themselves out of crisis in a vicious circle of budget cuts and faltering growth have returned to haunt markets in recent sessions.
The average return investors demanded on Ireland's 10-year bond fell to 5.386 percent compared to 5.537 percent at a sale in July. Spain sold 5.51 billion euros of 12- and 18-month treasury bills at yields of 1.84 and 2.08 percent respectively, down 38 and 24 basis points on July.
But the yield on Ireland's 2014 bond was still higher than in May, pointing to continuing nerves that it could be next to follow Greece into crisis.
Central bank governor Patrick Honohan warned that governments needed to convince investors that they were committed to cutting their budget deficits, even as he hinted the cost of the bank bailout may rise further.
"The sooner the markets are convinced, the sooner the interest spreads will shrink to the benefit of all," Patrick Honohan said in a speech to Renmin University in Beijing.
"There is, for these stressed sovereigns, no question as to whether national growth is best served by bringing the public finances back promptly to a convergent path."
Spain and Ireland have committed to getting their fiscal houses in order but anaemic domestic demand, soaring unemployment and, in Ireland's case, the cost of an ongoing bank bailout, are potential stumbling blocks.
MORE CUTS NEEDED
Ireland's budget deficit ballooned to 14 percent of gross domestic product, the highest in Europe, last year due to the cost of propping up nationalised lender Anglo Irish and it could explode to around 20 percent this year if Dublin injects an additional 10.05 billion euros into the bank.
The Anglo injection is meant to be a one-off and Honohan reiterated on Tuesday that Ireland was committed to reducing its deficit to an EU target of 3 percent of GDP by 2014.
Fitch ratings agency told Reuters that Dublin may have to slash more than the 3 billion euros in savings earmarked for the 2011 budget to fully restore investor faith in Irish finances.
"I think that the markets would welcome a larger cut, perhaps four billion, and I do appreciate that that will be difficult and politically unpopular," Chris Pryce, Fitch director for ratings in western Europe, said.
Dublin attracted total bids of 5.1 billion euros in Tuesday's sale, the strongest demand in an auction so far this year and in stark contrast to the ice-cool reception for Irish paper in the secondary market in recent weeks.
Ireland's debt management agency expected Irish yields to fall in the coming months. The Irish/German 10-year government bond yield spread is still north of 300 basis points.
"There's no doubt about that and there's still an 'Anglo Irish Premium' in that particular spread and some sort of certainty in the future of that bank would help bring it down," said Dermot O'Leary, chief economist at Goodbody Stockbrokers in Dublin.
Spain, which has hinted it could backtrack on some of its planned cuts in infrastructure spending, sold 5.51 billion euros of debt, at the top end of its target of 4.5-5.5 billion euros.
The spread on Spanish 10-year paper over German government debt contracted by around 9 basis points to 168 basis points on Tuesday.
Article by Reuters Carmel Crimmins and Nigel Davies
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