EURO GOVT-Spain, Italy yields fall; focus on German court

* Spanish, Italian yields fall, but stay at high levels
* Euro FinMins meeting provides no surprises
* French, Austrian, Belgian bonds may rally further

By Marius Zaharia and Emelia Sithole-Matarise
LONDON, July 10 (Reuters) - Spanish and Italian government
bond yields dipped on Tuesday on hopes Germany's top court will
give its blessing to efforts to deploy euro zone rescue funds
more flexibly, but only limited room was seen for further falls.
The Constitutional Court has begun a hearing into whether
the euro zone's bailout scheme and budget rules are compatible
with German law.
Finance Minister Wolfgang Schaeuble told the court that any
significant delay in approving the measures could fuel financial
market turbulence, though the head of the Bundesbank said speedy
ratification was no guarantee the debt crisis would not worsen.

Spanish 10-year yields were 21 basis points
lower on the day at 6.85 percent at settlement, while their
Italian equivalents fell 12 bps to 5.98 percent.
"There was some speculation about the ESM (bailout fund)
being treated with more urgency, but volumes are low and the
market is still holding up all right," one trader said. "There's
no real momentum behind the move."
Earlier, euro zone finance ministers agreed to grant Spain
an extra year, until 2014, to reach its deficit reduction
targets and set the parameters of an aid package for its banks
that it is hoped will prevent Madrid needing further aid.
But with 10-year Spanish yields close to the key 7 percent
level beyond which countries such as Portugal or Ireland were
eventually forced out of capital markets, investors continued to
fret about a potential sovereign bailout.

"I don't really see that anything from what the finance
ministers came up with is particularly reassuring. I can't see
that there's any good reason for Spanish spreads to tighten. The
issue about the overall size of the ESM rescue fund is still
there," said Elisabeth Afseth, rate strategist at Investec.
"I suspect we're going to see them (Spanish yields) back up
at 7 percent in the not too distant future. I wouldn't buy into
this rally in any significant sense."
Bund futures added 12 ticks to settle at 144.11,
still within sight of the one-month high of 144.28 hit on Monday
as sentiment in riskier assets remained fragile on investor
concern about implementation risks facing the region's latest
efforts to contain the debt crisis.

HUNT FOR YIELD
Two-year Spanish and Italian bonds rallied, outperforming
longer-dated paper and catching up with a wider move in
short-term debt in the euro zone following the European Central
Bank's cut in interest rates to record lows last Thursday.
Two-year German bond yields traded just below
zero, while equivalent French paper yielded 19
basis points. The latter yielded about 390 bps less than Italian
short-term bonds and 470 bps less than Spanish two-year bonds.
"The front end of Italy and Spain is too cheap really given
where other markets are trading. If you argue everything else is
at or going to zero then at some point you're going to see some
hunting for yield," one trader said.
Ultra-low yields in Germany are mainly pushing flows into
markets perceived as riskier but not as risky as Spain or Italy,
where investors can find better returns.
French, Austrian and Belgian bonds have all rallied across
the yield curve since the ECB's rate cuts.
Belgian 10-year yields were 7 bps lower at
2.81 percent, near the record low of 2.736 percent hit on
Friday. This compares with levels around 6 percent seen in
November, during the previous wave of the euro debt crisis.
Lloyds strategists have started positioning for a gradual
flattening of the French 2/10-year yield slope going forward as
investors some return higher up the curve.
"The front end will remain locked down, meaning any 10-year
rally could allow a test of the June lows at 2.25 percent," they
said in a note, recommending selling the July 2014 bond and
buying the April 2022 OAT at a spread of 226 basis points.