EURO GOVT-Moody's drives Spanish yields to lowest since April

* Spanish borrowing costs at lowest in over six months

* Bunds fall to three-week low as Moody's decision weighs

* Pick-up in 2-yr German yield could lure investors at sale

By Ana Nicolaci da Costa

LONDON, Oct 17 (Reuters) - Spanish government bond yields fell to their lowest since early April on Wednesday after Moody's kept Spain's investment grade rating, removing an immediate threat to the euro zone's fourth largest economy.

Moody's affirmation of Spain's Baa3 rating, with a negative outlook, eased widespread fears the country would be cut to "junk", leaving its bonds vulnerable to forced selling as they are shifted out of benchmark indices.

But Moodys kept pressure on Madrid to seek aid, specifically citing euro area and European Central Bank support as a reason it thinks Spain will be able to maintain access to capital markets at reasonable rates. Losing market access would not be compatible with Spain's current rating, a Moody's analyst said.

Spain's borrowing costs fell sharply, testing the lower end of recent ranges which have held on uncertainty over when Spain will seek support. That possibility has made investors reluctant to sell Spanish debt in recent weeks.

Moody's move also cooled demand for safe-haven debt but an auction of two-year German paper was expected to attract demand.

"It is a major surprise. I think the market was positioned for a downgrade. The only question for markets was (would it be) one notch or more notches," Piet Lammens, strategist at KBC said. "That's positive for risk appetite."

Spain's 10-year bond yield fell to 5.568 percent, its lowest in over six months, and last stood 23 basis points lower at 5.58 percent. Two-year yields fell below 3 percent for the first time in a month.

Italian funding costs fell in tandem with Spanish ones, with 10-year yields hitting their lowest since March at 4.82 percent. They were down 10 bps at 4.84 percent.

"It seems we are close to breaking the trading range that has been in place since September. For me, to have a real break, we need to go below 5.50 percent," Alessandro Giansanti, senior rates strategist at ING said, referring to 10-year Spanish debt.

BOND SALES

As sentiment towards riskier assets improved, German Bund futures fell to their lowest level in three weeks.

The Bund future was down 50 ticks at 140.28. On Tuesday, it saw its biggest one day fall in more than a week on talk that Spain may be close to seeking financial help.

The move lower in Bunds pushed 10-year German yields 4.2 bps higher to 1.59 percent, while two-year bonds yielded 0.08 percent before the auction.

"The fact that German yields now are trading at positive levels ... we are far away from the negative levels we saw in July, I think that should help for the pick-up at today's auction," Giansanti said.

Moody's decision not to downgrade Spain would also provide a favourable backdrop for an auction on Thursday, when Spain is set to test market appetite for three-, four- and 10-year paper.

"That will play in favour of more demand also from foreign investors at tomorrow's auction, so there will be more support for the 10-year auction," he added.

Spain sold more short-term debt than planned on Tuesday at slightly lower rates than a month ago, attracting investors who traded on expectations that a sovereign aid request could be near.