* Spanish yields turn flat after debt sale * Spanish auction gets high level of bids but poor pricing * Bunds reverse early losses, impact of U.S. QE uncertain By Marius Zaharia and William James LONDON, Dec 13 (Reuters) - Spanish bond yields rose after a debt sale fell short of market expectations on Thursday, underscoring the challenges the country will face raising funds in 2013. Madrid sold a modest 2 billion euros of three- and five- year paper and a longer-dated bond due in 2040, attracting a high level of bids, but the wide range of accepted offers hinted at weaker-than-expected demand. "At face value it shows that it's becoming trickier for Spain to refinance their debt, but it's not straight forward to draw any conclusions from this auction given that its just a week or so before Christmas and liquidity is thin," said Michael Leister, senior rate strategist at Commerzbank in London. "The first auction of next year is going to be really important as a signal." Spanish 10-year yields were last flat on the day at 5.40 percent, but 5 basis points higher than levels seen just before the results were announced. Yields on Spanish debt have fallen sharply in the second half of this year on expectations that Madrid will eventually seek financial help from its euro zone partners - a move which would enable the European Central Bank to buy its bonds. Spain has so far appeared reluctant to ask for a bailout, but many believe a hefty rise in its funding needs next year may soon force it to make the move. Madrid has already expressed worries that an increase in political tensions in Italy could hurt Spanish debt. At an Italian debt auction on Thursday, three-year borrowing costs dropped to their lowest since late 2010, despite increased volatility in the secondary market following Prime Minister Mario Monti's unexpected announcement at the weekend of his plan to step down early. Monti's decision, which brings forward an expected election by a few weeks to February, c aused a spike in Italian yields on Monday, but since then 10-year yields have come almost all the way back. They were last 3 bps lower on the day at 4.62 percent. "They've done okay (at the auction) but you would be foolish or complacent to think everything is hunky-dory because the Italian election will be more in focus in 2013," said Alan McQuaid, chief economist at Merrion Stockbrokers in Dublin. "As for Spain, they have a lot of debt to pay back in the next year or so and that's potentially problematic. Ultimately they would have to move and get a (bailout) deal." UNDERSTANDING FED'S MOVE German Bund futures rose in choppy trading as investors struggled to assess the long-term impact of the U.S. Federal Reserve's decision to buy more Treasuries. German bonds fell at the open before recovering to leave futures 23 ticks higher on the day at 145.49. The Fed said on Wednesday that it would buy $45 billion in Treasuries each month alongside an existing pledge to purchase$40 billion of mortgage-backed securities and would expand its purchases to include five-year notes. It also took the unprecedented step of saying it would keep interest rates near zero until the jobless rate falls to 6.5 percent, well below its current level, so long as inflation is contained. "It's quite thin volumes out there. It's hard to read because you can say more quantitative easing is a good thing for the U.S. economy and maybe we should be risk-on," said Rabobank strategist Lyn Graham-Taylor. "But you can read it the other way too, that the economy is still struggling and it's a risk-off trade. I don't think the market has made up its mind particularly yet." McQuaid at Merrion Stockbrokers also said there was a feeling that the Fed's move, although meant to stimulate the economy, actually highlighted how weak it is, causing prices to fluctuate. "People were quick to think it was good for riskier assets and not good for the core bonds," McQuaid said. "But from the way they (the Fed) phrased the statement last night you could see there was genuine concern that unemployment is not going to fall any time soon."