EURO GOVT-Spain leads periphery tighter; German sale strong

* Domestic buying sees Spain head peripheral rally

* Solid demand at German 5-year auction

* Next test Spanish, Italian auctions

By Kirsten Donovan

LONDON, Jan 11 (Reuters) - Spain led a rally in the euro zone periphery on Wednesday, easing funding concerns before Italian and Spanish debt auctions later in the week, while German yields fell after strong demand at a sale of five-year paper.

Spanish and Italian bonds have rallied this week, with the better tone partially attributed to comments from a Fitch Rarings official on Tuesday that the agency did not expect to cut France's triple-A credit rating this year.

"We've seen a small but steady spread tightening, particularly in Spain, and it looks like the locals are supporting the market. We're not seeing the same in Italy, however, and Spain is outperforming quite significantly," said Peter Schaffrik, rate strategist at RBC Capital Markets.

The spreads of Spanish bond yields over equivalent maturity German Bunds have narrowed sharply, despite the looming supply, with the 10-year spread around 17 basis points lower on the day and 40 bps tighter on the week.

Italian paper has underperformed. The 10-year spread over Bunds narrowed only around 10 bps and with 10-year bond yields just creeping below the 7 percent level widely seen as unsustainable.

One trader said that while there was significant buying of Spanish bonds, stemming from a major domestic bank purchasing large amounts on Tuesday, there was little buying of Italian paper and yields were just being marked down in the wake of the Spanish tightening.

"In Spain's case it's driven by domestic buying," the trader said.

"(The buying on Tuesday) gave the message that they intend to be pretty dominant in tomorrow's auctions so we're seeing a bit of a short-covering bid because a few of the brokers and foreigners got a bit short ahead of the auction."

Spain sells up to 5 billion euros of 2015 and 2016 paper on Thursday, while Italy offers up to 4.75 billion euros of five-year bonds on Friday.

GOOD DEMAND FOR GERMANY

Germany found solid demand for its five-year paper, despite a euro-era low yield of 0.9 percent, as concerns over Greek efforts to secure further aid boosted appetite for investments perceived as safe.

Unlike Spain, Greek yield spreads over Germany remain close to their record highs.

Liquidity from triple-A redemptions this month and a relatively small amount of paper on offer also helped the sale.

On Monday, investors more concerned with the return of, rather than the return on, their cash paid to lend to Germany with negative yields at a six-month bill auction .

With the euro zone debt crisis never far from investors' minds, David Riley, head of sovereign ratings at Fitch said the European Central Bank should ramp up its buying of troubled euro zone debt to support Italy and prevent a "cataclysmic" collapse of the euro.

March Bund futures were 19 ticks higher at 138.91, with 10-year cash yields down 2.7 basis points at 1.858 percent.

Bunds have traded in a roughly 1.5 point range this year in volumes still only around half of normal levels and with the market struggling for direction as positive U.S. data points to a brighter economic outlook, which could however be wiped out if the euro zone debt crisis gets worse.

The trader said many investors were yet to get involved in the secondary market.

"We've slowly been seeing some real money coming back to the market but new issues are where the cash is being put to work at the moment."