EURO GOVT-Italian, Spanish bonds rally before 3-yr ECB tender

* Expectations for large take-up at ECB's 3-yr tender
* But banks may not use money to buy peripheral debt
* Spanish T-bill yields plunge at auction
* Mood fragile, still no crisis solution in sight

By Marius Zaharia
LONDON, Dec 20 (Reuters) - Italian and Spanish bond
yields fell on Tuesday, with investors hoping banks will borrow
a large amount of three-year funds from the European Central
Bank later this week and spend some of the money on peripheral
debt.
A sharp fall in one-week borrowing from the ECB and a large
one-day loan take-up on Tuesday supported the view, as the
figures reflected banks were managing their cash to better
position for Wednesday's three-year injection.
Volumes in bond markets were thin, however, with many
reluctant to join the rally on the view that banks, under
pressure to deleverage, will use the money to roll over their
own debt rather then buy bonds that could eventually generate
mark-to-market losses.
Demand from banks at the three-year tender is expected to be
around 250 billion euros, according to a Reuters poll, although
forecasts ranged from 50 to 450 billion, indicating a high
degree of uncertainty.
"The expectations are massive," one trader said. "A higher
take-up is going to give the periphery some support, but we're
possibly setting ourselves up for a fall. It's not guaranteed
that they're going to buy (peripheral bonds)."
Italian 10-year government bond yields were
last 18 basis points lower at 6.685 percent, narrowing the
spread over Bunds to 476 bps. Equivalent Spanish paper
fell 11 bps to 5.15 percent.

Spanish T-bill yields plummeted at an auction which saw a
spike in demand, allowing the treasury to sell more than
planned.
Spain's debt has clearly outperformed Italy's over the past
10 days with the spread between the two countries' 10-year
yields widening by a full point in that period. That may be a
reflection of structural differences in the domestic banking
systems in the wake of the three-year tender, analysts said.
"In Spain, the cajas don't have publicly quoted shares and
that makes them more willing to help the sovereign and pick up
the yield differential," said Elisabeth Afseth, fixed income
analyst at Evolution Securities.
"But in the wake of MF Global, it's not going to be an awful
lot of other people willing to take on this trade in any kind of
size. Most of the banks are probably overweight compared to what
they would like to be in sovereign debt already."
MF Global filed for bankruptcy in October after it was
forced to reveal it had made a $6.3 billion bet on European
sovereign debt, spooking investors and customers.

SEASONAL RALLY
Spanish two-year yields were 11 bps down at
3.44 percent, having fallen around 3 full points over the past
month, leading a strong rally in short-term euro zone debt,
which is expected to be used as collateral at the ECB tender.
But bid/ask spreads of over 100 cents for Spanish paper
indicated that volumes were two times thinner than last month.
"It is seasonal. In January we will see the Italian and
Spanish yields spiking higher again," Lloyds rate strategist
Achilleas Georgolopoulos said. "It is going to be quite heavy in
terms of issuance and quite heavy in terms of market reaction."
Overall sentiment remained fragile, with a long-term
solution to the euro zone debt crisis still elusive.
European policymakers agreed to boost the International
Monetary Fund's resources by 150 billion euros, falling short of
a targeted 200 billion euros after Britain bowed out.

President Mario Draghi reiterated that the ECB's purchases
of sovereign debt were temporary and limited, again pouring cold
water on any expectations the central bank might intervene more
actively in tackling the crisis.
"At the end of the day our core view is that we're still in
trouble and I don't see any reason for Bunds not to be
supported," the trader said.
Bund futures were down half a point on the day to
137.89, with German 10-year yields up 4.5 basis
points to 1.926 percent.