* Spanish debt risk premium hits euro-era high
* Spanish yield curve flattens further
* Italian yields approach Irish counterparts
By Ana Nicolaci da Costa and Emelia Sithole-Matarise
LONDON, July 20 (Reuters) - Ten-year Spanish government bond yields hit their highest levels since the euro was created, above the 7 percent danger level, on growing doubts that the euro zone's fourth largest economy will be able to avoid a direct bailout.
News a region in Spain would apply for financial help from the central government reinforced concerns the country may eventually run out of funds. The rubber-stamping of a rescue package for Spain's troubled banking sector did little to allay fears over sovereign finances.
Short-dated bonds came under heavier pressure, flattening the Spanish yield curve further in a sign of mounting credit worries.
"The more pressure you put on the front end, when you consider how bid core front-ends are, that tells you something significant because it is saying that the near-term risk of default is going up through the roof," Charles Diebel, head of market strategy at Lloyds Bank.
"It's exactly the dynamic you saw in all of the other curves before they went into a bailout. You actually saw things like the Greek curve invert," he said, referring to short-term yields going higher than long-term yields.
Asked when such an inversion may take place for Spain, he said: "It always happens faster than you think. They haven't got the summer, put it that way."
Spain's heavily indebted eastern region of Valencia said earlier it would apply to Madrid for financial help in a move analysts worried would further stretch the country's finances especially as the government expected the economy to stay mired in recession well into next year.
Ten-year Spanish government bond yields hit a euro-era high of 7.317 percent, and were last up 26 bps at 7.28 percent.
Above 7 percent, yields on equivalent Greek, Portuguese and Irish bonds quickly spiked making funding costs prohibitive and forcing them to seek international aid.
The premium investors paid to hold Spanish bonds rather than their German counterparts rose above 600 basis points, to a euro-era high of 616 bps.
Auctions this week showed Spain can still access markets but at an increasing cost to the Treasury.
Given how high borrowing costs are, even for the short end of the curve where the Treasury is doing the bulk of its issuance, analysts worry Spain may soon struggle to raise funds.
Five-year Spanish yields hit a euro-eara high at 6.928 percent, up 46 bps on the day, while two-year yields spiked 62 bps to 5.86 percent.
"Spain didn't trade well after the auction yesterday. To me it's only a matter of time before it goes for the full bailout," a trader said.
Italian 10-year yields followed Spain higher, with investors fretting that the euro zone's permanent ESM rescue fund, due to come into effect this month, was insufficiently funded to effectively contain the nearly three-year-old debt crisis.
"We're convinced the market wants to test the actual readiness of the ESM to intervene to see how this will be able to go," said Norbert Wuthe, a rate strategist at Bayerische Landesbank.
"We'll see spreads in Spain, predominantly, and also Italy rising," he said.
Italian 10-year yields rose as far as 6.20 percent, coming dangerously close to those on debt issued by Ireland, one of the euro zone countries to have been bailed out. Ten-year Irish bonds last yielded 6.23 percent.
Investors have been steadily switching towards bonds issued by more secure euro zone countries, pushing yields lower on the region's 'core' issuers.
German Bund futures were up 63 ticks on the day at 145.77 while cash 10-year bond yields fell 5.6 basis points to 1.17 percent.
Bunds have gained for three straight weeks but have recently been outpaced by the likes of French and Belgian debt, highly-rated bonds that offer better returns.
"There is still a bid for safety and a hunt for yield, so this is favouring core markets as well as curve-flatteners, as investors go further out (along the maturity curve) because yields at the short end are very low or negative," said Patrick Jacq, strategist at BNP Paribas in Paris.
The premium investors pay to hold French rather than German debt has narrowed 16 basis points over the past month to 91 basis points, while the Belgian equivalent has fallen 21 bps to 130 bps.