* Bunds rise after sharp sell-off
* Markets wait for Fed QE decision
* Good demand at Italy's 6.5 bln euro bond sale
By Kirsten Donovan
LONDON, Sept 13 (Reuters) - German government bonds rose on Thursday with selling the previous day seen overdone, but a more positive tone in euro debt markets since a German court backed the bloc's rescue fund kept yields near recent highs.
The main focus was a U.S. Federal Reserve policy announcement at 1630 GMT, with the central bank likely to launch a third round of bond purchases - dubbed QE3 - to try to breathe life into the sluggish economy.
"It will be a massive disappointment if they don't do anything, we're looking for QE3 and some extension of the zero interest rate policy," a trader said. "If we don't get that it's probably going to be another excuse for Bunds to sell off."
German Bund futures were up 41 ticks at 139.97, with 10-year yields 3.5 basis points lower at 1.56 percent, having tested the top of their recent trading range.
"There's probably some fast money taking profit on short (positions) and other people looking to re-establish some long (positions)," a second trader said, referring to bets the market will fall or rise.
"We're still in a low rates environment ... and by no means out of the woods in Europe yet."
Investor appetite for riskier assets got a big boost on Wednesday when Germany's Constitutional Court cleared the way for the European Central Bank to buy bonds of struggling euro zone countries - a major plank in policymakers' plans to curb the region's debt crisis.
That spurred demand at an Italian bond sale, allowing the country to sell 6.5 billion euros of bonds, including 2026 paper - the longest-maturity conventional bond Italy has tried to sell in more than a year.
"They are very solid figures. The issues were slightly expensive versus the secondary market and the volumes look very strong ... 1.5 billion euros of the 2026 paper. That was the one to watch given the long maturity," said Michael Leister, rate strategist at Commerzbank.
"There is decent demand out there for risk and peripheral paper and obviously yesterday's German court ruling and last week's ECB announcement have underpinned this move."
Ireland also sold T-bills on Thursday, as it paved the way to make a full return to bond markets, paying the same to borrow for three-months as Italy did the previous day.
Spanish 10-year government bond yields were 8 basis points higher at 5.74 percent, having fallen from over 7 percent in late July. The Italian equivalent was up 2.5 bps at 5.06 percent.
"We're facing the potential expansion of QE by the Fed and there's a lot of help being thrown at the various problems out there so it feels OK for now," said ING rate strategist Padhraic Garvey.
"I can't imagine it will last for the rest of the year and I think we'll get another bout of negativity, but for today, and into next week and the week after, it feels OK."
Key for both Spain and Italy in the longer term will be whether they can draw back some of the international investors who have dumped their bonds this year.
Traders said demand for the paper, although picking up, still came overwhelmingly from domestic investors, although one said he had seen some switching from equities and corporate bonds - which have rallied since June - into peripheral bonds.
Although viewing the ECB plan as positive for markets, Jack Kelly, a fund manager at Standard Life, which has $247 billion under management, said that alone was probably not enough.
"To get long we really need to see the nature of the ECB buying and their reluctance, or not, and what the scale of the buying is. It may be longer than the market thinks before the Spanish actually request aid," Kelly said.
"We think peripheral spreads are likely to stabilise around these levels and the volatility may drop, but we don't see much outperformance from here as we've already had such a big move."
Analysts also say the threat of further credit rating cuts - Spain is already on the brink of "junk" status - will deter investors and economic growth will be necessary to entice buyers back.