* Strong Spanish auction spurs confidence, bond yields fall
* Cyprus remains crucial to near-term outlook, Bunds edge up
* Array of possible outcomes force investors to wait and see
By William James and Marius Zaharia
LONDON, March 21 Spanish government bond yields fell on Thursday, pushed lower by a strong Spanish debt sale, as investors kept faith with the euro zone's large peripheral states despite Cyprus's struggle to avoid financial meltdown.
Demand for debt issued by large, vulnerable euro zone states such as Spain and Italy remains buoyed by the belief that the European Central Bank will step in with bond-buying support if they came under pressure and the bonds look attractive because of the high yields they offer.
Spanish 10-year yields fell 11 basis points on the day to 4.89 percent, almost unchanged from levels seen before Cyprus shocked markets at the weekend by unveiling a plan to tax savers' bank deposits to fund a bailout.
The drop in Spanish yields accelerated after an auction in which Madrid sold 4.5 billion euros worth of bonds, more than the 4 billion euro maximum target. Borrowing costs fell and analysts said demand was strong.
"Clearly there is no Cyprus angst or Italy angst in that sale. They sold more than they were targeting," said Marc Ostwald, strategist at Monument Securities in London.
Nevertheless, Cyprus remains an acute source of concern for the market as Nicosia searches for a new way to secure an international bailout after Cypriot politicians overwhelmingly rejected the deposit levy plan earlier this week.
The European Central Bank has given Cyprus until Monday to fashion a plan or face lose the funding lifeline keeping its banks afloat. A senior EU official made clear to Reuters that the bloc was ready to see the bankrupt island banished from the euro in the belief it could then contain damage to the wider economy.
"I'm amazed there's not been a bigger sell-off," said Rabobank strategist Lyn Graham-Taylor. "I suspect we'll be continually watching headlines over the next couple of days and the weekend... it's difficult to analyse the impact until they reach some kind of decision."
Traders highlighted a Reuters report showing euro zone finance officials acknowledged being "in a mess" over Cyprus during a conference call on Wednesday, discussed imposing capital controls and talked openly about the country leaving the euro zone.
"The market has been trying to shrug it off, with Cyprus being a small country, but the prospect of one country leaving the euro zone is enough to give a bid to Bunds," one trader said.
Strong demand for German bonds, sought as a safe haven in times of market stress, helped Bund futures rise despite historically high prices. Cash yields were expected to stay close to 2013 lows in the near term.
Bund futures were last 14 ticks higher on the day at 144.44, while 10-year cash yields fell 1.1 basis points to 1.367 percent, having hit a 2013 low of 1.343 percent on Tuesday.
One trader said a range between 144.00 and this week's high of 144.82 should hold near-term. However, he warned against underestimating the seriousness of the situation, pointing to this week's gains in the Bund future of more than a full point.
A second trader said the market seemed to want to buy Bunds after any dip in prices. "Nobody wants to be caught short but they don't want to be caught too long either," he said.
"The market seems to be very nervous. Cyprus is indeed a small economy ... but when you see it managed to move the market that much it's a bit scary."