* Portuguese yields fall as govt tries to defuse crisis
* Euro zone debt markets stabilise before Spanish sale, ECB
* Spanish auction seen supported by domestic demand
* Investors look to ECB for reassurance after market turmoil
LONDON, July 4 Portuguese yields fell but held above 7 percent on Thursday as the government sought to defuse a political crisis and investors refrained from placing big bets before a Spanish auction and a European Central Bank meeting.
Portugal's crisis, triggered by the resignation of two ministers this week, saw its 10-year government bond yields spike on Wednesday above 8 percent and raised concerns the country would struggles to exit as planned its 78-billion-euro bailout programme. Other lower-rated euro zone yields also rose but less sharply.
But Portuguese bonds rebounded on Thursday while Spanish and Italian debt prices were flat, with investors braced for an auction of 3-4 billion euros of Spanish debt.
Investors, concerned the euro zone debt crisis could flare again, will look to ECB President Mario Draghi's news conference after Thursday's monetary policy meeting for reassurance.
"It's a combination of mildly positive moves overnight and the fact that we have Draghi today. So people don't want to trade too heavily into the ECB," said Alessandro Tentori, global head of rates strategy at Citi.
Ten-year Portuguese government bond yields fell 9 basis points to 7.44 percent.
Two-year bonds underperformed, with yields up slightly at 5.51 percent, suggesting investors remained concerned about the country's credit risk. Analysts flagged worries about Portugal's debt sustainability when 10-year yields rose above 7 percent on concerns about U.S. monetary stimulus.
Tentori expected more volatility in the periphery in the second half of this year.
"There is a general recognition that the ECB's arsenal is really depleted ... the value of the OMT (ECB's bond-buying program) has been tested recently by (Federal Reserve Chairman Ben) Bernanke's press conference, so overall people don't feel as confident as they were in Q4 2012 or maybe the first quarter of this year when it comes to peripheral holdings."
The sharp price moves could complicate Spain's bond auction, although the sale is widely expected to be supported by domestic investors, while the recent pick-up in yields should also attract buyers.
Spanish borrowing costs over 10 years were up slightly at 4.78 percent, while the Italian equivalent rose a similar amount to 4.56 percent.
"It will be difficult after the Portuguese tensions, there might be some nervousness... but all in all we think the auction should go OK," Piet Lammens, strategist at KBC said.
The ECB is expected to leave interest rates unchanged at a 0.5 percent but to try to reassure investors rattled by fresh turmoil in Europe and the U.S. Federal Reserve's plans to curb monetary stimulus. Trade is expected to be quiet due to a public holiday in the United States.
"After what happened in Portugal, (Draghi) has no reason to sound more hawkish, on the contrary, he might continue to say that an exit policy for the ECB is still in the very distant future," Lammens said.