By Vicki Schmelzer

New York (MNI) – Forget about finding the elusive Carmen Sandiego,
the market Tuesday wanted to know where in the world is the European
Central Bank?

Risk assets were pummeled by the fact that Eurozone peripheral
spreads widened further after European and U.K. traders returned from
the long Easter holiday weekend, with no guiding ECB hand to prevent
yields from rising.

Italian 10-year yields hit 5.69% and the spread over German Bunds
hit 404 basis points, the widest levels seen since late January.

Ten-year Spanish yields topped out just shy of 6.0%. The 10-year
last closed above 6.0% December 13, well before the ECB conducted the
December and February LTROs.

The market struggled to understand why the ECB did not step in and
also debated the motivation behind the lack of action.

“After two three-year LTROs, the ECB is less inclined to revamp the
SMP in size,” said Norbert Aul, European Rates strategist at RBC Capital
Markets.

It is clear that the central bank wants to see the EFSF in action,
in secondary and primary market instrument purchases “as well as
insurance style partial protection certificate,” he said.

“This would require an EFSF Memorandum of Understanding with Spain
(or any other sovereign in need of support), while also the EFSF will
have to build up its ‘war chest’ via bill and bond funding,” Aul said.

Traders took the lack of ECB action to mean that the market was on
its own, for now, a thought that inspired risk aversion rather than risk
appetite.

“The message is clear — the ECB buys bonds and upgrades these
bonds in the moment of purchase from a junior to senior position,” said
Hans Redeker, head of Global FX strategy at Morgan Stanley.

“The more the ECB buys, the bigger the senior relative to the
junior position,” he noted.

However, in the end, it will be the junior position that ends up
with the haircut, not the ECB’s portfolio, he said.

“Should the ECB buy now, the market will ask for an increasing risk
premium (for) holding the junior position,” Redeker explained.

The ECB ends up being “cornered by their own action,” he observed.

As for what to expect next from the central bank, there are other
possibilities, analysts said.

In terms of the prior LTROs positive effect on the market, “the
bloom is off the rose,” said Marc Chandler, global head of currency
strategy at Brown Brothers Harriman.

The December and February LTROS did serve to ease sovereign risk
and also bank roll-over risk, so in that, the operations can be deemed
successful, he said.

Nevertheless, “the positive effects of the LTROs are diminishing,”
as is “the ability of the LTROS to push the market in a positive
direction,” Chandler said.

Going forward, the ECB could opt to do another LTRO, this one of a
different tenor, perhaps 5 years, he suggested.

The ECB could also further liberalize the collateral rules for
banks, he said.

Unless the market decides to start buying peripheral debt, the
central bank will, at some point, likely have to take action to prevent
yields from rising further, Chandler said.

“An under-appreciated aspect of the virtuous cycle, was the bank
balance sheets improved not just because of cheaper cost of capital, but
because there was a significant rally in the banks’ assets–i.e.
sovereign bonds,” he said.

Currently, this process is “in reverse,” with the “virtuous cycle”
instead becoming a “vicious cycle,” he said.

“Barring a fresh ECB initiative, it is difficult to see how
officials break the vicious cycle,” Chandler said.

Euro-dollar fell steadily Tuesday, largely in response to widening
peripheral spreads, and weighed on other FX pairs.

The euro was trading at $1.3092 in afternoon action, after holding
in a $1.3055 to $1.3144 range.

After peaking at $1.3485-90, in the run-up and on the day of the
February 29 LTRO, the euro has been contained by a $1.3002 (March 15) to
$1.3385 (March 27) range.

A clear-cut break of the psychological $1.3000 support, if followed
up by a break of the February 16 lows at $1.2973, would suggest that the
euro is moving back into a $1.2500 to $1.3000 range.

Widening peripheral spreads and the euro tumble took a toll on risk
assets overall, with stock and commodity prices falling also.

While the S&P 500 was down about 1.3% at the time of this writing,
the German DAX closed down 2.49% at 6606.43 and the French CAC-40 closed
down 3.08% at 3217.60.

The Reuters-Jefferies CRB index held at 301.36 Tuesday afternoon,
after trading in a 300.93 (nearly a four-month low) to 304.86 range.

With risk sentiment again eurocentric, market players will closely
eye such upcoming events as the ECB meeting May 3, French elections
April 22 (first round), Greek elections (likely May 6) for direction.

In the near-term, how the market embraces this Thursday’s four
Italian BTP auctions — see MNI European and UK Government Debt Auction
Calendar on the mainwire at 10:35 a.m. ET for details — will be a key
driver, traders said.

–email: vschmelzer@marketnews.com (212) 669-6438

** MNI New York Bureau 212-669-6430 **

[TOPICS: M$U$$$,M$X$$$,M$$EC$]