* Italian yields resume rise after auction, ECB steps in * Yields hit euro-era high at 5-yr bond sale * Bunds rally with crisis far from over By Kirsten Donovan LONDON, Nov 14 Italian government bonds reversed early gains on Monday as relief over the appointment of a new head of government gave way to concerns over the size of the task still facing policymakers trying to tackle the euro zone debt crisis. Yields at a 3 billion euro five-year Italian bond sale hit euro-era highs of 6.29 percent, despite demand being enough to see the deal price through levels seen in the secondary market in early trading. The European Central Bank (ECB) stepped in to buy bonds shortly after the auction as yields began to rise, traders said. Following former Prime Minister Silvio Berlusconi's resignation, Italian President Giorgio Napolitano asked former European Commissioner Mario Monti on Sunday to form a government to restore market confidence. "From the political side this is the critical foundation Italy needs to regain credibility in the market," said Norbert Aul, rate strategist at RBC Capital Markets. "From here the work has to continue and we need to see austerity measures and structural reforms put in place but the challenges remain basically the same." The political change was mostly priced into the market last week, helping bring yields across the Italian curve back below 7 percent, but investors cautiously waited for profound reforms to be taken by the country's new leadership before showing more willingness to buy its debt. "(Yields) are still clearly eye-watering ... This can only be done for quite a limited time-span," said Commerzbank strategist David Schnautz. Traders reported mixed demand at the auction, where the paper is initially allocated among banks who are primary dealers. One said there were signs of decent domestic demand from accounts who were sitting on cash from recent redemptions but another said they had seen no demand from domestic or international accounts going into the sale. Benchmark Italian 10-year yields were 10 basis points higher at 6.61 percent after hitting a euro-era high of 7.5 percent last week. Five-year yields were little changed at 6.55 percent, with ECB offers reportedly focused on that area of the curve. "Ultimately the auction looked good on paper but it was a massively reduced size and only one line," one trader said. Any bouts of relief from the euro zone debt crisis have proved short-lived with efforts to construct a financial firewall to protect Italy, Spain and potentially France struggling to overcome legal and political obstacles. Greece also appointed a new prime minister late last week, former ECB vice president Lucas Papademos, easing fears the country could drop out of the euro zone. "In short, the market can be more confident in the ability of Greece and Italy to pass the necessary fiscal measures to regain control of their debt, but the economic and structural issues facing the euro zone remain a problem," said Credit Agricole CIB rate strategist Peter Chatwell. With the crisis far from over, December German Bund futures were 79 ticks higher at 138.05, off session highs of 138.24 and still well below last week's record high of 139.58. But UBS technical analyst Richard Adcock said there was no evidence of bearish reversal patterns forming and that while the contract held above 137.02 -- the 38 percent retracement of the October to November recovery -- the market could rise back above the 138.25 level to retest the highs. Benchmark 10-year German yields were down 7 basis points at 1.81 percent. Later on Monday the ECB will announce how much it spent buying peripheral debt -- mainly Italian bonds -- in the secondary market in the week until last Tuesday. The ECB was said to have stepped up its purchases towards the end of last week but this will not be included in Monday's figures. Analysts expect the central bank buying to continue this week in the face of heavy supply, with Spain and France holding auctions on Thursday.