* Spanish auction falls short of maximum issuance target * Auction spooks market, Spain sells off while Bunds rally * German sale solid, demand for high-quality bonds intact By Emelia Sithole-Matarise and William James LONDON, Dec 5 Spain's bond yields jumped on Wednesday after demand at its latest bond sale undershot expectations, prompting a shift to more liquid assets that pushed German and French debt higher. A strong auction had been anticipated, but the 4.25 billion euros raised fell short of the 4.5 billion euro maximum target, and analysts also pointed to the wide range of accepted bids as a sign of weaker overall demand. The sale triggered a swift selloff in Spanish debt, driving 10-year bond yields 16 basis points higher to 5.43 percent while equivalent French yields fell below 2 percent for the first time in the euro era and German Bunds rallied. Spanish bonds were seen staying under selling pressure with more supply due next week and investors fretting about how it will manage to meet a heavy issuance schedule early next year if it does not trigger European Central Bank bond purchases. Madrid has so far refrained from making the aid request needed to activate the ECB scheme and the bank is expected to give little steer on the issue at its policy meeting on Thursday. "The main difficulty for Spain is the wall of supply in January. I find it very difficult to see how Spain can surmount that without requesting support," Societe Generale strategist Ciaran O'Hagan said. "It would be wise for them to ask for support now before we hit that supply hump. It's best to be preventive and do it right now rather than wait." The auction brought recent gains in peripheral bonds to a halt although the reversal took back only a small portion of a rally that pushed yields to their lowest since March on Monday. Spain's 10-year bond yield premium over Germany rose to 407 basis points, up 20 bps on the day but still below highs of over 650 bps hit in July. The spread has tightened sharply since the ECB promised in September to support heavily indebted euro zone countries, including Spain, with bond purchases if they applied for help. Some market participants say it could widen further in the absence of such a request. "The whole ECB buying promise remains untested as long as Spain is refusing to request aid beyond the bank support, so the (spread tightening) effect of it may fade over time," Investec rate strategist Elisabeth Afseth said. CORE SUPPORT In contrast to Spain, a sale of two-year German bonds was sufficiently well bid to keep auction yields below zero as investors paid up for the security and liquidity of assets issued by the euro zone's strongest sovereign. "The auction was good. It's the last auction for this year so they ended the programme pretty well," said Artis Frankovics, strategist at Nomura in London. "Fundamentals haven't changed for the Schatz. There's still demand for high quality collateral." The weak Spanish sale just before the Schatz auction helped demand but the underlying desire to hold German paper remains strong, supported by longer-term worries about the euro zone and more immediate concerns about U.S budget talks. German Bund futures settled 54 ticks up on the day at 143.28 with cash 10-year yields 4 bps lower at 1.35 percent. Politicians in the United States are trying to agree a compromise to avoid tax rises and spending cuts that could snuff out a nascent economic recovery. "If they don't resolve this 'fiscal cliff', we've got this dread of their economy going back into recession which will have a real detrimental effect for the world," said Alan McQuaid, chief economist at Merrion Stockbrokers. The focus will now shift to Friday's U.S. non-farm payrolls report which is used as a key indicator of the economy's health.