* Highly-rated euro zone debt rallies, Belgium outperforms
* Spain, Italy worries to continue ahead of Sept. ESM ruling
* U.S. data to set tone into Federal Reserve report
By William James
LONDON, July 16 (Reuters) - Belgian, French and Austrian bonds rallied on Monday as investors sought out low-risk government debt that carries a higher return than ultra-low yield German Bunds.
Rising safe-haven demand pushed yields lower on bonds at the safer end of the euro zone credit spectrum as Spain and Italy struggle to retain market confidence that they can keep refinancing debt while reining in their deficits.
Spreads between German debt and that issued by other highly rated euro zone states narrowed, with the biggest moves seen in shorter-dated bonds as investors shied away from the low or even negative returns offered by German bonds.
"Confronted with the option of buying (German) Schatz at a negative yield or buying something which doesn't have such a high rating but has similar correlations and comes at a pickup - that's why there's such demand for French, Dutch, Austrian and even Belgian paper," said Peter Chatwell, strategist at Credit Agricole.
Belgian five-year debt was among the strongest performers on the day as investors snapped up the 104 bps of extra yield it offers over the German equivalent.
Nevertheless, demand for Bunds remained solid, with two-year Schatz yields 5 basis points below zero and 10-year futures contracts up 18 ticks at 144.90.
Trading was expected to remain light and price action choppy throughout the day as activity slows down over the summer. Last week, total traded volume in the Bund future was its lowest since early May.
Spanish 10-year bond yields were 11 basis points higher on the day at 6.77 percent, but traders reported that few bonds were changing hands, resulting in exaggerated price movements.
Confidence in the ability of the euro zone's rescue plans to shore up Spanish and Italian markets looks likely to remain shaky over the next few weeks after Germany's top court set a Sept. 12 deadline for a decision on whether it would block the latest plan for the permanent euro zone bailout fund.
That means the fund will not any time soon be using the new powers granted to it by euro zone leaders last month in the hope that it could stave off a market collapse for Italy and Spain.
"That's not great news as it just increases the uncertainty and effectively prevents the ESM (European Stability Mechanism)from being where it should be," said Eric Wand, strategist at Lloyds Bank in London.
"But I think after last week, when they said they needed further time, the market kind of understood it wouldn't happen this side of the summer break."
Elsewhere, U.S. retail sales data may sway expectations ahead of Federal Reserve chairman Ben Bernanke's biannual testimony to the U.S. Congress on the economy on Tuesday and Wednesday, as markets look for signs of whether the Fed will undertake new stimulus measures.
Analysts said if Bernanke sounded less keen than expected on the prospect of renewed bond-buying, equity markets were likely to suffer, providing another boost for low-risk government bonds.