* Semi-core euro zone debt rallies, Belgium outperforms
* Spain, Italy worries to continue ahead of Sept. ESM ruling
* U.S. retail sales data disappoints
By Marius Zaharia
LONDON, July 16 (Reuters) - French, Austrian and Belgian government bonds rallied on Monday, outperforming other euro zone debt, as investors sought assets in countries that offer higher returns than Germany but are less risky than Italy and Spain.
Confidence in the euro zone's ability to stem selling pressure in its peripheral debt markets is likely to remain low over the next few weeks as Germany's top court set a Sept. 12 deadline for a decision on whether it would block the latest plans for the permanent ESM euro zone rescue fund.
That means that the European Stability Mechanism would not be able to use its powers to recapitalise banks or intervene in bond markets any time soon.
Scared away from Italy and Spain, international investors are faced with the dilemma of whether to buy debt in safe-haven Germany - where yields up to the three-year maturity are negative - or accept higher risk for slightly higher returns.
While German bonds built on last week's gains, the yield spread between them and the so-called "semi-core" group narrowed. Belgian five-year debt was among the strongest performers, with yields falling 13 basis points to 1.30 percent - one full point over German counterparts.
"There's enough tolerance to buy anything up to Belgium," said Padhraic Garvey, head of investment grade debt strategy at ING in Amsterdam.
"The fundamentals haven't changed. France is still the weakest of the triple-A rated and so on. So it may not last forever but it may still last for a while."
German Bund futures were 42 ticks higher at 145.14, with 10-year yields down 3.5 basis points at 1.221 percent, some 10 basis points above a record low hit in June.
Safe-haven flows have also been fuelled by below-expectations retail sales data in the United States, which stoked worries about a flagging economy and raised bets that the Federal Reserve may ease monetary policy further.
Ten-year U.S. T-note yields on Monday hit the 1.442 percent level set on June 1, which was the lowest going back to early 1800s, according to data compiled by Reuters.
Federal Reserve Chairman Ben Bernanke gives his biannual testimony on the economy to the U.S. Congress on Tuesday and Wednesday.
Spanish 10-year bond yields were 18 basis points higher on the day at 6.84 percent, but traders reported that few bonds were changing hands, resulting in exaggerated price movements.
Equivalent Italian yields were 8 basis points higher at 6.14 percent.
Investors are fretting about the possibility that Spain may eventually need a sovereign bailout, in addition to a deal of up to 100 billion euros already agreed for its ailing banks. If that happened, selling pressure on Italian debt may intensify, and that market is too big for the ESM to save.
The decision by Germany's constitutional court to allow itself almost two months to reach a verdict on the ESM means any discussion about increasing the size of the fund is even further away than some had hoped.
"It just increases the uncertainty and effectively prevents the ESM from being where it should be," said Eric Wand, strategist at Lloyds Bank in London.