LONDON, July 25 (Reuters) - German government bonds fell on Wednesday on signs that euro zone policymakers may be opening up to the idea of giving the bloc's ESM rescue fund a banking licence to improve its ability to fight the debt crisis.
European Central Bank Governing Council member Ewald Nowotny told Bloomberg there were arguments favouring the French-backed proposal. The ECB has so far repeatedly rejected the idea, arguing it would be thinly disguised monetary financing of governments.
Bond markets remained cautious. The European Stability Mechanism is not functional yet, with the German Constitutional Court expected to rule on it by mid-September, and worries that Spain may need a full sovereign bailout dominated trading.
"Markets are still angry that the ESM is not there yet," said Lloyds rate strategist Alessandro Mercuri.
German Bund futures were last 36 ticks lower on the day at 144.67, with 10-year yields 2.7 basis points higher at 1.262 percent.
Concerns about the impact of the euro zone crisis on even the euro zone's strongest countries also weighed on Bunds.
Moody's cut the credit outlooks of triple-A-rated Germany, the Netherlands and Luxembourg to negative earlier this week, citing the risk that Greece may leave the euro and the potential cost of shoring up large economies like Spain or Italy.
The Ifo German business sentiment reinforced those concerns, dropping more than expected to its lowest in 28 months in July.
Bunds have underperformed other safe havens this week. The spreads between German 10-year bonds and their U.S. and UK counterparts narrowed by some 15 basis points this week to 14 and 27 bps, respectively.
Societe Generale strategists recommended favouring those bonds against Bund, saying UK gilts could soon yield less that German paper. One trader disagreed, saying the limited range of safe-haven instruments would maintain flows into Bunds.
"At the end of the day, when the U.S. got downgraded we didn't see a whole lot of underperformance of Treasuries against Bunds so I don't see why this should continue," the trader said. "I think they (spreads) have room to go back especially if periphery news deteriorates."
Germany sells up to 3 billion euros of bonds maturing in 2044 later in the day.
"Get that out of the way and the Bunds can rally again," the trader said.
Spain is increasingly expected to have to seek a full bailout on top of the already agreed rescue of its banks, as its borrowing costs have settled above levels deemed as sustainable.
It needs to find 50 billion euros in funding this year and an auction of three- and six-month bills on Tuesday at which it paid the second highest yield on short-term debt in the euro era showed its access to market was shrinking.
Spanish 10-year government bond yields were 3 basis points higher at 7.67 percent, close to a euro era high of about 7.75 percent.
Only more decisive anti-crisis measures in the near term could ease the strain on Madrid, analysts said.
"If we do see some sign that we're moving in the right direction in terms of the ESM coming together market access should not be disrupted completely," Mercuri at Lloyds said. (Editing by Nigel Stephenson)