EURO GOVT-Italian, Spanish yields off lows on talk of ECB buying
* Talk of ECB bond buying brings Italian yields below 6 pct
* But pressure on BTPs, peripheral debt remains
* Bunds fall after hitting highest since November (Updates to close)
By Ana Nicolaci da Costa and Emelia Sithole-Matarise
LONDON, July 12 (Reuters) - Peripheral euro zone government bonds recouped losses and rallied on Tuesday as talk of central bank buying of some lower-rated debt and the prospect of a new EU crisis meeting prompted profit-taking in benchmark German Bunds.
Earlier in the session, yields on Spanish and Italian bonds hit their highest levels in 14 years -- with the Italian 10-year yield coming close to the 7 percent level analysts see as an unsustainable cost for Italy's borrowing.
Analysts said traders did not want to be caught off guard should the extra EU leaders summit, slated for Friday, and unconfirmed talk of European Central Bank buying, indicate policymakers had been seized with a new sense of urgency to resolve the euro zone crisis.
The talk gave traders an opportunity to cash in on recent gains in German bonds in an otherwise Bund-positive environment: European finance ministers acknowledged for the first time that some form of default may be needed to cut Greece's massive debts. .
"Spreads have come in from the wides this morning but I think it's just fast money who are pushing this market around. I haven't heard of any real money getting involved in Italy or Spain," a trader said, adding that given the recent Bund rally, some profit-taking was inevitable.
"I don't think you can be at all bearish on Bunds...The market is still seen as very fragile. Nothing much has come up in terms of solving the sovereign debt crisis."
Italian/Bund 10-year yield spreads reached a euro life-time high above 350 basis points but later settled back to 288 basis points, 15 basis points tighter on the day.
Earlier, Italian 10-year yields jumped more than 30 basis points on the day to break above 6 percent for the first time since 1997.
They later slipped back below 6 percent on market talk the ECB was buying Italian and Spanish bonds even though bond traders who normally see such transactions said there was no sign of purchases. Yields settled down 8.4 bps at 5.60 percent.
Spanish/Bund 10-year yield spreads hit a high of around 380 basis points before falling to 318 basis points, 21 basis points tighter on the day.
Peripheral bonds have been hammered in recent sessions as contagion spread beyond weaker euro zone members to engulf Italy -- the euro zone's third largest economy.
The scale and speed of the market moves raised concerns over the cost of financing Italy's 1.6 trillion euro debt burden. Indeed, Italy's short-term cost of borrowing surged to its highest since the 2008 financial crisis at a government bill sale on Tuesday. .
The fear is that if Italy were to become the next victim of the euro zone debt crisis it would be too large to be bailed out in the way Portugal, Greece and Ireland have been.
<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic comparing Italy with other 'debt-heavy' EMU countries
Euro zone finance ministers late on Monday promised cheaper loans, longer maturities and a more flexible rescue fund to help Greece and other EU debtors but failed to set a deadline to act.
Earlier, Germany's finance minister had said a second Greek rescue package could wait until September after euro zone finance ministers effectively accepted that private sector involvement meant a so-called selective default was likely, despite the ECB's vehement opposition to such a move.
As EU officials began to publicly acknowledge the risks, investors were losing hope of a sustainable solution any time soon.
"Without getting bogged down in a long list of policy errors during the crisis, current levels of Bund yields and periphery spreads probably best express just how much the market has lost faith in policymakers," Michael Leister, a strategist at WestLB said.
Benchmark German Bund futures FGBLc1 reversed gains to settle down 25 ticks at 128.89. They earlier hit their highest since November at 130.91.
Cash 10-year Bund yields were up 3 bps at 2.70 percent, while the two-year Schatz yielded 1.28 percent , less than the ECB's key refinancing rate of 1.50 percent as the market priced out expectations of further interest rates hikes this year . (Graphics by Scott Barber)
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