A Trader's Guide to Spanish Budget Defeat and What Comes Next

(Bloomberg) -- Spanish Prime Minister Pedro Sanchez lost the battle to approve his 2019 budget in a parliamentary vote in Madrid on Wednesday.

The Socialist leader is widely expected now to call a snap election, less than a year after he won power as the head of a fragile minority government.

Sanchez may wait until holding his Cabinet Meeting this Friday before calling the early elections, most likely for April 28, La Vanguardia newspaper reported, citing unidentified government sources. Spain’s government bonds were underperforming their euro-area peers after the decision.

Here’s a look at what’s happened, what to expect, and what it could mean for markets.

How did we get here?

The Socialist Party was able to claim the premiership through a unique set of circumstances: A landmark corruption ruling turned public opinion against Sanchez’s conservative predecessor in the aftermath of Catalonia’s push for independence. That persuaded both separatists and left-wing lawmakers to back his effort to oust ex-prime minister Mariano Rajoy of the People’s Party.

But Sanchez has only 84 lawmakers in the 350-strong chamber, and getting that same coalition to back important legislation so far has proved beyond him.

A Trader's Guide to Spanish Budget Defeat and What Comes Next

With separatist leaders going on trial this week in Madrid on charges of sedition and rebellion, lawmakers from Catalonia are reluctant to be seen lining up alongside the government for fear of provoking a backlash among their supporters.

So what next?

The right-wing opposition was out in force last weekend, filling central Madrid with tens of thousands of supporters demanding an early election.

Sanchez won’t want to be seen letting his opponents dictate events. He is also betting that the longer he can hold on, the more time he’ll have for his policy measures -- like an increase in the minimum wage -- to take effect and potentially boost his support.

All the same, the signs are that the failure of the budget could be enough to force his hand.

Who would win an election?

Sanchez’s Socialist Party is leading in the most recent polls, but it’s still a long way short of the votes needed for a majority.

Instead the most likely outcome for the next government would be a coalition of three parties from the center-right and right wing, which have seen their support boosted by more trenchant opposition to Catalan separatism.

Pablo Casado of the PP and Albert Rivera, the leader of Ciudadanos, are vying for second place in the polls and whoever comes out on top may have the best claim to lead the next government. They may need the support of a new nationalist party, Vox, to form a majority.

So no chance for Sanchez?

The prime minister is one of the great escapologists in European politics. He’s already been ousted by his own Socialist party establishment once, and came back to reclaim the leadership. When he called a no-confidence vote against Rajoy last year, few people initially gave him much chance of success.

If he does pull it off, he’ll come back with a stronger hand than he has now.

So there will be a more stable government either way?

Probably. But the risk, as so often in Spain, lies in what the Catalan separatist groups would do.

If the general electorate splits down the middle, then the center-left bloc led by the Socialists or a potential bloc of the three parties on the right could equally need help to take office.

Given their turbulent recent history, there’s no guarantee separatists will fall in with either grouping. That could leave Spain facing a new form of political gridlock.

How are traders preparing?

A traditional trade based on a parliamentary government foundering or falling in Europe would be to sell that nation’s 10-year debt versus a similar German bund, betting that the yield spread between them will widen.

That worked in a small way for traders on Monday, when the gap increased just minutes after Efe newswire reported Sanchez was mulling whether to call early elections for April.

A Trader's Guide to Spanish Budget Defeat and What Comes Next

The spread widened about three basis points. The move reversed following reports in other media that the government had denied a vote would be held in April.

Is anyone recommending any trades?

BBVA is recommending investors sell the “belly” of a butterfly and buy the wings.

In other words, short Spanish five-year debt and go long two- and 10-year bonds, betting that the mid-range will underperform the extremes. If the trade works, it would be a reversal of the trend since November, when five-year debt outperformed during a period of relative political calm.

A Trader's Guide to Spanish Budget Defeat and What Comes Next

JPMorgan Chase & Co. recommends buying neighbor Portugal’s bonds versus Spanish notes. Anticipating more “political noise” from the kingdom, it suggests buying Portuguese debt due in April 2027 and selling Spanish bonds with a matching maturity.

“Portugal is a more convincing story to buy than Spain in 2019 due to lower headline risk,” the bank’s analysts wrote in a Feb. 9 note.

A Trader's Guide to Spanish Budget Defeat and What Comes Next

©2019 Bloomberg L.P.