EURO GOVT-Investors snub ECB liquidity promises, Bund rallies
* German Bunds rally to highest since September 2010
* Two-year bond yields tumbled on liquidity prospects
* Italian/German 10-year yield spread at euro era highs
LONDON, Aug 4 (Reuters) - The Italian government bond yield premium over Bunds rose to euro era peaks on Thursday on signs the European Central Bank had no immediate plans of buying Italian and Spanish bonds to arrest a worsening sovereign debt crisis.
The ECB said after leaving interest rates unchanged at 1.5 percent that it would broaden its liquidity operations as it revived its bond buying programme in the secondary market by purchasing Portuguse and Irish bonds.
A euro zone monetary source said ECB bond purchases in the secondary market would be confined to those countries, fueling worries that the debt crisis would sweep Italy and Spain into its vortex.
"The SMP is back but it's not in the right places, what's going to stop us attacking Spain and Italy over the summer months, cause I can't think of anything," said a trader in London.
"There is no buying of Italy and Spain going on and there won't be, so why can't we push these markets to 7 percent yields, I think we can quite easily," the trader said.
The 10-year Italian/German bond yield spread widened to 392 basis points, the most since the launch of the euro in 1999 while the equivalent Spanish spread expanded to 400 bps from 386 bps at Wednesday's settlement.
German Bund futures FGBLc1 jumped to their highest level in nearly a year while the prospect of more liquidity in the euro system took two-year German bond yields to their lowest since January, steepening the two-/10-year yield curve.
THE MAGIC NUMBER
Italian and Spanish 10-year bond yields rose firmly above 6 percent and investors feared that a key 7 percent level was now easily within reach.
That level is considered a point of no return, above which funding costs become unsustainable and a country can quickly struggle to raise funds in commercial markets.
Portugal, Greece and Ireland -- whose yields are currently at double digits -- had to seek financial rescue and are mostly dependent on the ECB for their funding.
Ten-year Portuguese and Irish bond prices were up sharply with yields more than 20 basis points lower on the day.
"The alarm bells (are) ringing in the ECB tower," Kornelius Purps, fixed income strategist at UniCredit said.
"Now the ECB is not only going to expand or extend the existing measures, the ECB is coming up with an emergency funding line for 6-months which is definitely a signal that the ECB sees pressure out there."
The two-year German government bond yield fell as far as 0.84 percent -- far below current euro zone interest rates.
Money markets were beginning to price in a possibility of a rate cut early next year, even though the ECB hiked interest rates in July. Increased liquidity made it hard to make out an accurate picture of interest rate expectations.
The German Bund future settled at 132.79, up 98 ticks on the day after hitting a high of 133.17.
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