July 2, 2012 / 4:50 PM / 5 years ago

EURO GOVT-Spanish bond rally stumbles on euro zone deal doubts

* Italian yields fall but Spanish bond rally loses steam

* Euphoria over euro zone deal ebbs on implementation doubts

* Finland says to block plan for ESM to buy bonds

* Bunds rally, aided by uncertain growth outlook

By Emelia Sithole-Matarise and Kirsten Donovan

LONDON, July 2 (Reuters) - Spanish bond yields rose on Monday as euphoria in riskier assets over last week's euro zone deal to stabilise debt markets ebbed on concern over potential implementation hurdles and an uncertain global growth outlook.

Under pressure from Spain and Italy, euro zone leaders agreed on Friday to let their rescue fund inject aid directly into stricken banks from next year and intervene on bond markets to support troubled members, moves that helped yields on the two countries' bonds ease.

But with investors hungry for details of the measures and questions over how far the limited funds available in the region's rescue funds could be stretched and as weak U.S. manufacturing data added to global growth concerns, safe-haven German Bunds rallied.

Spanish 10-year government bond yields reversed earlier falls to end higher after the Finnish government said Helsinki and its Dutch allies would block the bailout fund from buying bonds in the secondary market.

"It (Finland's comment) highlights there being significant implementation risk to the broad outlines that were given by euro zone leaders on Friday," said Elisabeth Afseth, a rate strategist at Investec.

"I suspect the rally will be relatively short-lived because it might make people cover short positions...Given the size of the rescue fund it may mean it's going to be a matter of selling into it rather than investors deciding to invest alongside the ESM."

Ten-year Spanish yields were up 6 basis points at 6.4 percent and two-year yields were down by a similar amount at 4.35 percent but off their best levels of the day. However, these moves still left the yield curve around 60 basis points steeper since Thursday's close.

"The steepening is being led by the front end as default risk is priced out of the market so using this as a barometer of residual optimism from the summit, it suggests that the proposals do appear to have legs," Rabobank strategist Richard McGuire said.

The aggressive falls in Spanish yields on Friday was also prompting some profit-taking before a Spanish bond auction on Thursday. The sale will be the first test of market sentiment since the European Union summit last week, with the country expected to sell up to 2.5 billion euros of paper.

Italian 10-year yields continued last Friday's falls, shedding 9 basis points to 5.74 percent, while two-year yields dropped 11 basis points to 3.69 percent.

Spain and Italy's yields - or funding costs - remained high versus historical levels and some strategists remained wary of peripheral bonds.

"We've been shying away (from peripheral bonds) for a while and we haven't changed that," said Peter Schaffrik, strategist at RBC Capital Markets.

"We haven't been short either (before Friday's summit)...but again the crisis is not solved and there's not enough on the table to make this a sustained rally...strategically it's too early to be engaged."

ECB DECISION LOOMS

Trading volumes are likely to remain thin ahead of Thursday's European Central Bank policy meeting and Friday's U.S. employment data, which is often a big market mover.

The ECB is expected to cut its main refinancing rate 25 basis points to 0.75 percent on Thursday, with expectations that the deposit rate it pays banks to park cash overnight may also be cut to zero.

"A rate cut will be welcome, but while a short-term boost to sentiment, this is not a game changer," Societe Generale economists said in a note.

"With credit channels still impaired, a rate cut is unlikely to significantly improve funding conditions for banks or sovereigns in the periphery."

September Bund futures rose 78 ticks to settle at 141.68, reversing some of last week's falls with unexpectedly weak U.S. manufacturing data spurring demand for safe-haven government debt. Cash German 10-year yields were six basis points lower at 1.52 percent.

"We still have significant risk in the euro area. It's not the best environment for risk assets and this is driving demand for German Bunds as well as the expectation that the ECB will move further on stimulus to the economy in terms of rate cuts," said Alessandro Giansanti, a strategist at ING.

Coupon and redemption payments from Germany totalling around 40 billion euros this week should help support core paper, along with the prospect of another 50 billion euros of cash inflows from France, Austria and the Netherlands next week.

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