EURO GOVT-Bunds rally as euro zone economy slows

* Bunds rally as euro zone growth slows

* 10-year German yields extend falls below 2 percent

* Spanish bond yields rise, more seen

By Kirsten Donovan

LONDON, March 21 (Reuters) - German government bonds rallied on Thursday on renewed buying of safe-haven assets as a surprising downturn in the euro zone economy focused investor attention on the ability of euro zone countries to meet budget targets.

Business surveys showed the region's economy contracted more than expected in March, hit by a sharp fall in French and German factory activity, dashing hope the region may avoid falling into a new recession.

"Everyone was so focused on Greece and the debt crisis is still on everyone's mind, but attention is focusing back on to fundamentals," said DZ Bank rate strategist Michael Leister.

"The PMIs alone don't make for such a big story but they fit into the bigger picture risk-off theme that we're seeing."

Spanish and Italian 10-year bond yields were around 9 and 7 basis points higher respectively.

After a brief respite for financial markets after Greece dodged default earlier this month, Spain has increasingly taken the crisis spotlight.

A relaxation of budget targets has rattled investors and yields on Spanish 10-year bonds have risen more than 20 basis points this week to stand at 5.50 percent.

Concerns over the banking sector, which is laden with bad loans and increasing amounts of its sovereigns bonds, are not helping.

"It's not just Spain, there's also political risks in the Netherlands and so in the short-term spreads and yields in these countries have widening potential," Leister said.

That widening is likely to continue until early next month when the next wave of U.S. employment and manufacturing data is due, he added. Further signs of a U.S. recovery may take the shine of safe-haven assets again after triggering last week's sharp sell-off.

Benchmark 10-year Bund yields fell further below 2 percent after dipping back below the level, the upper end of this year's trading range, on Wednesday. They were last 6 bps lower at 1.93 percent.

"There's still plenty of trouble ahead for Europe," a trader said, adding that for the last two sessions clients had been buying Bunds and selling "everything else".

June Bund futures were 64 ticks higher at 136.97, having hit a session high of 137.14.

Societe Generale technical analysts cautioned that although the bounce from last week's lows around 135.30 was "impressive", it was too early too conclude the sell-off was over and a rise to the 137.75 area could trigger further selling.