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Wednesday Look Ahead: Wall Street Looks to Europe for Reprieve from Volatility

Traders fret the only thing that will halt the volatile selling in risk assets is a clear solution to Europe's sovereign debt crisis, and that seems elusive.

Even as stocks Tuesday recovered from a 3 percent intraday decline, traders said the market was carving out a new range and it will not resume an upward path until there is some sign that Europe is stable. The failure of a Spanish bank on the weekend and the merger of others was part of the catalyst behind this week's selling.

Besides Europe, another geopolitical story pushed stocks lower Tuesday and helped fan a global equities sell off. North Korea, which has been blamed for torpedoing a South Korean war ship, was reported overnight to be getting 'combat-ready.' NBC News, citing U.S. intelligence and military officials, reported Tuesday morning that there was no evidence of that.

The European debt crisis will stay in the spotlight Wednesday, as U.S. Treasury secretary Tim Geithner arrives in London after a visit to China this week. He is expected to push for a stress test of European banks, according to reporting by CNBC's Steve Liesman.

"Clearly, U.S. policy makers have been trying to share what they learned during the crisis. Again, there was a lot of mistakes and there was still controversy over the actions, but at least we haven't fallen into another Great Recession," said Edward Keon, managing director and portfolio manager at Quantitative Management Associates.

"The key will be whether we are able to stop the bleeding and prevent the downward spiral. The best hope to do that is probably some strong action by European governments and other policy makers. If you think of the United States' response to the subprime crisis, it took a while to get it right,"said Keon. :..It's not easy to deal with these major crisis and get them right. It takes a little time to agree on the proper course...My guess is we're headed in the right direction at least. It was only a short time ago that the ECB said they were not going to consider purchases of assets, and they changed their mind."

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

In early New York trading, rumors circulated Tuesday that the Fed, working with the ECB, could move to lower the penalty rate to access dollar funding via its swap lines, as dollar Libor rates continued to rise. MKM chief economist Michael Darda, in a note, said more aggressive actions from the ECB are likely required to stop Europe from falling into a double dip recession and stop the potential for defaults in some of the weaker Euro zone countries. Darda said the ECB could lower its 1 percent refinancing rate, as well as expand its balance sheet.

Despite Europe's trillion dollar rescue plan, markets have been skeptical of the ability of European officials to work together to solve its problems without letting the crisis, which started in Greece, spin out of control. A unilateral move by Germany to ban the naked shorting of key German banks and sovereign debt last week worried the market, in part because Germany acted alone. More details of proposal circulated Tuesday.

"I've been describing this as two opposing trends," said Keon, who says the market right now is not focused on the good news about the U.S. economy and earnings. "On the other side, you have fears about the Great Recession II or Financial Crisis II," he said.

"Valuations are not crazy. This is not risky assets priced at very high levels. We think valuations are pretty reasonable," he said.

Keon said his portfolios have been slightly overweight risky assets for about a year. "So the strategy has taken a hit as risky assets got beaten up. We pretty much stayed the course...We haven't been buying heavily and we haven't been shorting either. We were not overweight enough that we were devastated by the pull back. We still think the fundamentals will win out and now that you've had that, you have some pretty substantial values," he said.

The Dow Tuesday dove 292 points, or 2.9 percent before a late day recovery that took it to 10,043, just 22 points below Monday's close. The S&P 500 also went on a wild ride, erasing 32 points, or 3 percent, before finishing a fraction of a point higher at 1074. Materials, financials and consumer discretionary stocks helped lead the reversal.

Buyers continued to flock into the 10-year Treasury note, pushing its yield at one point to 3.08 percent early Tuesday. It finished the day with a yield of 3.158 percent. The Treasury ran a weak auction Tuesday for $42 billion in 2-year notes, at the lowest yield ever -- 0.769 percent. There are $40 billion 5-year notes up for auction Wednesday at 1 p.m.

Brian Edmonds, who heads Treasury trading at Cantor Fitzgerald said the bond market appears to be responding more to deflation fears than the flight to quality trade, or the front end of the market would have seen more of the buying that's targeted the 10-year. He also said the move signals that some investors were on the wrong side of the market.

"I would expect at some point we're going to see a good run up in rates, and higher yields before we go much lower in yield. People have been grabbing up securities for the last week and a half, and a month and half ago we had 4.04 (percent) 10-years," he said.

Spreads Tuesday on all types of debt continued to widen, with corporates and high-yield issues ending at their widest levles of the day, despite the stock market rally.

"There's definitely a repricing of risk," said Joel Levington, managing director of corporate credit at Brookfield Investment Management. "I'm a worrier so I worry about most things and this would be toward the top of my list." Levington pointed to a sharp move in the newly issued 10-year bonds of Abbott Labs. They priced Monday with a yield of 4.1 percent. The yield moved up to about 4.25 percent Tuesday morning, before coming back in.

"When you're seeing that happen to high quality credit in a short period of time, obviously that's going to filter through" and less diverse names will get punished, he said. Levington said the highly rated, blue chips are not seeing much affect, but the selling is focused on lower quality companies and companies, like those in the materials industry, that would benefit from a global recovery.

The dollar Tuesday was 0.4 percent higher against the euro, which finished the day at $1.2334. Commodities sold off with oil down another 2.1 percent to $68.75 per barrel, now down more than 20 percent lower in just 16 sessions.

What Else to Watch

Wednesday's data includes durable goods at 8:30 a.m. and new home sales at 10 a.m.

Investors will also be watching the latest as BP moves ahead with its top kill plan to stem the leak of oil into the Gulf of Mexico. A public hearing on the spill will be held by the Coast Guard and Minerals Management Service in Kenner, Louisiana.

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  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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