* Domestic buying sees Spain lead peripheral rally
* Solid demand at German 5-year auction
* Next test Spanish, Italian auctions
* Renewed talk of French downgrade cools French debt rally
By Emelia Sithole-Matarise and Kirsten Donovan
LONDON, Jan 11 (Reuters) - Spain led a rally in lower-rated euro zone government bonds on Wednesday, easing funding concerns before Italian and Spanish auctions in the next two days, while German yields fell after strong demand at a sale of five-year paper.
Buying by domestic banks helped Spanish debt outperform German benchmarks, and a successful auction on Thursday could spur more tightening in yield spreads. But analysts said the relief would be shortlived given the absence of a resolution to the euro zone debt crisis.
Renewed talk of an imminent cut to France’s triple-A ratings served to remind investors of fallout from a debt crisis now in its third year, prompting French bonds to give up earlier gains over German peers and driving Bund futures to two-month highs.
Concerns that Greece may be heading for a messy default if it fails to reach a deal with private bondholders necessary to secure more aid were also keeping intact the safe-haven bid.
The spreads of Spanish bond yields over equivalent maturity German Bunds have narrowed sharply, despite the looming supply, with the 10-year spread as much as 17 basis points tighter on the day to 344 bps, and 40 bps tighter on the week.
“A good result for Spain would mean they raise more money than they target ... and the rally would continue and will have a good momentum for Friday for the Italian auction, but will it last?” said Lloyds’ strategist Achilleas Georgolopoulos.
“It will last until the next negative news comes out. It seems we have a series of good auctions, positive comments and we are riding on it ... That doesn’t mean Italy (10-year bond yield) is going to massively move below 7 percent,” he said.
Italian paper has underperformed Spanish peers. The 10-year spread over Bunds only narrowed by around 10 bps and 10-year bond yields only crept just below the 7 percent level that is widely seen as unsustainable.
One trader said that while there was significant buying of Spanish bonds, stemming from a major domestic bank purchasing large amounts on Tuesday, there was little buying of Italian paper and yields were just being marked down in the wake of the Spanish tightening.
“In Spain’s case it’s driven by domestic buying,” the trader said.
“(The buying on Tuesday) gave the message that they intend to be pretty dominant in tomorrow’s auctions so we’re seeing a bit of a short-covering bid because a few of the brokers and foreigners got a bit short ahead of the auction.”
Spain is set to sell up to 5 billion euros of 2015 and 2016 paper on Thursday, while Italy will offer up to 4.75 billion euros of five-year bonds on Friday.
With the euro zone debt crisis never far from investors’ minds, David Riley, head of sovereign ratings at Fitch, said the European Central Bank should ramp up its buying of troubled euro zone debt to support Italy and prevent a “cataclysmic” collapse of the euro.
Germany found solid demand for its five-year paper, despite a euro-era low yield of 0.9 percent, as concerns about Greek efforts to secure further aid boosted appetite for investments perceived as safe.
Unlike Spain, Greek yield spreads over Germany remain close to their record highs.
Fresh talk of an imminent cut to France’s triple-A credit rating spurred the momentum in Bunds, leaving the March Bund future within sight of a record high of 139.58 reached on Nov. 10. The contract settled at 139.35, up 63 ticks on the day, while the 10-year French debt yield spread over Bunds was little changed around 136 bps, having tightened to 131 bps intraday.
Bunds have traded in a roughly 1.5 point range this year with volumes still only around half of normal levels. The market has been struggling for direction as positive U.S. data points to a brighter economic outlook, which could however be wiped out if the euro zone debt crisis worsens.
The trader said many investors were yet to get involved in the secondary market.