* Spanish bond yields rise after debt auction * New Spanish govt needs to outline new measures: Fitch * Belgian yields soar on political deadlock, contagion By Emelia Sithole-Matarise and Ana Nicolaci da Costa LONDON, Nov 22 (Reuters) - Spain's borrowing costs surged at an auction of short-term debt on Tuesday, keeping investors on edge and pushing up yields on peripheral euro zone government bonds on scant signs of political initiatives to tackle the debt crisis. Belgian government bond yields also jumped as ongoing political deadlock in the country fuelled worries about its ability to brave a crisis that is entering its third year and now impacting less risky countries like France. Spain paid the highest interest in 14 years to sell short-term debt in an auction seen as a test of investor sentiment after the centre-right Popular Party won an election on Sunday. The average yield for a three-month bill more than doubled to just over 5 percent from almost 2.3 percent a month earlier and yields were higher in the secondary market. Fitch Ratings said the new government must surprise markets with a radical fiscal and structural reform programme if it is to improve expectations of its capacity to grow and cut debt within the confines of the euro zone. "It doesn't look great, the continuing trend towards ever higher yields to get anything done, it has to be concerning," said Gary Jenkins, head of fixed income at Evolution Securities. Yields on Spanish 10-year bonds were up 4.7 basis points on the day at 6.64 percent, on five-year paper they rose 16 basis points to 6.11 percent and two-year bond yields jumped 16 basis points to 5.9 percent. The 10-year yield was 22 bps from converging with that of Italy. Some strategists expect it to go back to trading at a premium over Italian debt as investors assess the new Spanish government's commitment to an austerity programme. The spread between the bid and ask price on 10-year Italian bonds has widened sharply since October from around 25 cents to 110 cents, suggesting the market is becoming more illiquid. Italian two-year yields jumped 44 bps on the day to 7.03 percent, rising back above those of 10-year BTPs, reflecting renewed investor fears that they may not get their money back. The 2/10-year yield curve had been trading normally over the past couple of weeks as shorter-dated yields fell back below longer maturities on guarded optimism that a new Italian government could do more to pursue fiscal tightening measures. The move higher in Italian yields came even as the European Central Bank was seen buying short-term Italian bonds, according to three traders.BELGIAN WOES Ten-year Belgian government bonds underperformed the rest of the euro zone sovereign debt in that maturity, with two traders saying the political deadlock in the country and the prospect of supply next week had weighing on bond prices. Belgian 10-year government bond yields soared 27 basis points to 5.10 percent -- having hit its highest since 2002 at 5.11 percent -- one day after the lead negotiator in Belgium's drawn-out government formation tendered his resignation after talks for a 2012 budget ground to a halt. The move threatens to derail the country's near 18-month search for a new administration. "It could be a strategy to try and strong-arm the opposing parties to come to some form of agreement perhaps, but it potentially is a worrisome development because (nobody will be controlling the process) if that strategy backfires," Richard McGuire, rate strategist at Rabobank said. "The system is in ever increasing crisis mode and the leeway for delaying (action) is limited to say the least given the elevated nature of yields in the Spanish and Italian debt markets. Spain and Italy are very close to being effectively shut out of the market." Not only are yields on Italian and Spanish 10-year bonds hovering close to a psychologically important 7 percent level, beyond which funding costs are perceived to be unsustainable but there are signs that contagion is spreading to less risky, triple-A sovereigns. Ten-year French government bond yields were up 6.2 basis points at 3.5 percent and the Austrian equivalent rose 9.2 basis points to 3.52 percent. Despite the backdrop, German Bund futures only settled 10 ticks higher at 137.25. Gnawing at sentiment, Jefferies Group Inc became the latest bank to cut its holdings of debt of Europe's struggling states, saying late on Monday it had reduced its exposure by a further 50 percent. Jefferies executives said the company had reduced gross exposure to debt of Greece, Ireland, Italy, Portugal and Spain by a total of nearly 75 percent since early November and now has a net short position of $134 million in those countries' bonds. Traders and strategists said this trend was likely to continue with banks looking to lighten their exposure to risk going into year-end.