* Bunds lower ahead of expected ECB rate hike
* Portuguese bonds pause but Italian, Spanish yields rise
* Spain passes market test with decent demand at bond auction
LONDON , July 7 (Reuters) - German government bond yields were steady on Thursday, supported by fears the euro zone debt crisis was intensifying, with a solid Spanish bond sale doing little to relieve tension.
Two-year German yields were off lows hit in the previous session, with strategists saying a move to close to 1.54 percent looked overdone given the European Central Bank is poised to raise interest rates to 1.5 percent later in the day.
Concerns the debt crisis could still spread further have grown since Moody’s slashed Portugal’s credit rating to junk late on Tuesday.
Portuguese bond yields were mostly steady after rising by over 4 percentage points on Wednesday with 2-year paper yielding 17.76 percent and 10-year paper — at around 55 percent of face value — yielding 14.25 percent.
Decent demand, thanks to domestic buyers, at a Spanish auction removed an immediate worry however with Madrid selling almost 3 billion euros of 3- and 5-year bonds
“It’s a lot better...but obviously the yields are that much higher than last time and in the long run, with the amount of debt Spain has to sell, this creeping cost of issuance is not a good thing,” said Marc Ostwald, strategist at Monument Securities in London.
Yields on Spanish and Italian bonds found little respite however with analysts saying recent moves in Italian paper were concerning.
The 10-year Italian/German yield spread widened to a euro-era high of 225 basis points earlier in the day as Italian 10-year yields approached 5.2 percent, their highest levels since 2008.
“What we’re seeing now, much more than a year ago is that there is a more serious contagion to the larger peripherals and on the political side it is much less clear what Europe wants, where Europe goes and how much cohesion there is,” said Peter Schaffrik, rate strategist at RBC Capital Markets.
And Commerzbank strategist Marcel Bross said there was little scope for peripheral yields to tighten back in, at least for now.
“With all key players in the ‘Greek drama’ remaining on collision course for the time being we see limited room for relief in intra-EMU spreads after yesterday’s blood bath.”
“The prevailing extreme volatility may warrant further room-making of market makers ahead of next week’s...(Italian) BTP auctions.”
Greek creditors have gone back to the drawing board in an attempt to thrash out a rollover plan for the country’s debts after Standard & Poor’s said a French plan would likely result in a “selective default” rating.
“With EU officials and politicians desperate to avoid any kind of default it is difficult to see how this ends well unless some form of fiscal union and joint debt issuance becomes reality,” said Gary Jenkins, head of fixed income at Evolution Securities.
“If contagion spreads to the point where Spain is unable to fund itself in the market and there is concern over private participation in any bailouts, it is difficult to see how highly-indebted Italy could escape unhurt.”
With over 860 billion euros of debt maturing in the next five-year, Jenkins said if yields stay at current levels, Italy’s annual debt service costs will increase by 9.7 billion euros a year or about 0.65 percent of GDP by the end of 2015.
The European Central Bank is almost certain to raise interest rates later on Thursday and will show no let-up in its insistence that governments solve Greece’s debt crisis without triggering a default credit rating .
“If they give any strong guidance (on whether they will hike again or not) the market is going to move quite significantly... because the expectation is for a very balanced statement,” RBC’s Schaffrik said.
“If something big comes out, given the market volatility these days a 10 basis point move (in two-year yields) is not out of the question.”
September Bund futures were 32 ticks lower from Wednesday’s settlement close at 126.20, although little changed from levels seen in after hours trading. The contract rallied over 80 ticks on Wednesday.
Two-year bond yields were flat at 1.584 percent, with 10-year yields up 2 bps at 2.954 percent .
France also sold 8.35 billion euros of 2020 and 2021 and 2029 bonds, with demand for core paper leading to a solid result .
Reporting by Kirsten Donovan; editing by Patrick Graham