* Irish bonds rally after ECB deal * Draghi plays down rise in money market rates * ECB says will monitor impact of euro strength * Markets interpret that as softer tone, Bunds rally By Marius Zaharia LONDON, Feb 7 (Reuters) - Irish government bond yields fell on Thursday to levels last seen before the global financial crisis after Dublin reached a deal that will reduce its borrowing needs over the next decade. At the top end of the euro zone credit scale, German debt yields fell sharply after European Central Bank President Mario Draghi played down a rise in money market rates and said the bank will monitor the strength of the euro. The deal between Ireland and the European Central Bank to ease the burden of debt taken to rescue its banking system puts Ireland on track to end its reliance on bailout money and come out of its debt crisis. The ECB allowed Ireland to stretch the cost of bailing out Anglo Irish Bank over 40 years, a move which the government estimates will reduce the borrowing needs by 20 billion euros over the next decade. "It shows there's no shortage of goodwill towards Ireland and that's a good thing. It should lock in this improved market sentiment in Ireland," said Chris Scicluna, head of economic research at Daiwa Capital Markets. The October 2020 Irish bond yield fell as low as 3.952 percent, the lowest seen in an equivalent Irish benchmark bond since early 2007, before the subprime crisis started, according to Reuters data. Shorter-dated bond yields also fell, while the cost to insure Irish debt against default via five-year credit default swaps fell 17 basis points to 143 bps, according to data monitor Markit. Elsewhere in the euro zone's lower-rated periphery, Spanish bonds erased early-session losses after a debt auction drew better-than-expected demand. Ten-year yields were last 2 bps lower at 5.42 percent. Spanish bonds took a beating earlier this week as a corruption scandal led to calls for Prime Minister Mariano Rajoy to resign, raising worries that Spain may delay the implementation of reforms aimed at overcoming its debt crisis. Italian bonds also faced selling pressure this week as the party led by former premier Silvio Berlusconi is gaining in opinion polls before elections later this month, raising concerns about the future path of reforms in one of the most indebted countries in the world. Ten-year Italian bonds were last 3 bps higher at 4.58 percent. Sanjay Joshi, head of fixed income at London and Capital, sold all his Italian and Spanish bonds last week. "Concerns about Italian elections and also Spain made us flatten out on the periphery about a week ago. They've had quite a good run so we took the opportunity to take profit and we've done pretty well on it," said Joshi, whose firm manages about $1.5 billion in fixed income assets. ž DRAGHI'S HINTS After the ECB left interest rates unchanged at 0.75 percent, Draghi said he will monitor the impact of a strengthening euro on the economy and cautioned against reading too much into a rise in overnight interbank Eonia rates. Draghi estimated that, even after the initial repayments of the second of the ECB's LTRO crisis loans, excess liquidity would not drop below 200 billion euros - the level at which overnight borrowing costs typically begin to rise. "It's bullish ... he is hinting that if policy does get tighter from the payback then he will do something about that.(Also) he was more concerned about the euro. That means that if the euro goes up the market can expect some reaction," RBS rate strategist Harvinder Sian said. German Bund yields fell 2.2 basis points to 1.609 percent, while two-year yields fell 3.4 bps to 0.177 percent. Sian said Schatz yields could fall by about 10 basis points in the near term due to Draghi's comments.