LONDON, July 25 (Reuters) - German government bonds fell on Wednesday after an auction of long-term debt drew weak demand and on signs that euro zone policymakers may be opening up to the idea of giving the bloc's permanent rescue fund a banking licence.
Concerns about the impact of the three-year-old debt crisis on even the region's strongest countries also weighed on Bunds, although analysts did not expect them to fall much lower in price in the near term as Germany is still regarded as a safe haven.
The concern that Spain may eventually need a full sovereign bailout was likely to remain the main market driver in coming weeks, while the risk that Greece might leave the euro zone was still lurking in the background.
Citing the potential cost on Germany should any of those risks materialise, Moody's cut the outlook for the euro zone powerhouse's triple-A rating to negative earlier this week.
"Fundamentally, there is a case for a pull-back in German yields, however the euro crisis is solved," said Chris Scicluna, head of economic research at Daiwa Capital Markets, describing his medium-term view.
"However, we see a likelihood of an intensification of the risks associated with Spain and Greece in the coming weeks so there's a chance ... investors seeking euro denominated assets will favour Bunds over anything else."
Bund futures were last 79 ticks lower on the day at 144.24, while 10-year Bund yields were 6.3 basis points higher on the day at 1.297 percent. They hit a record low of 1.126 percent on Monday before Moody's outlook revision.
One way to reduce the perceived direct cost of solving the crisis for countries like Germany may be allowing the European Stability Mechanism to borrow money from the European Central Bank to increase its firepower.
ECB Governing Council member Ewald Nowotny told Bloomberg there were arguments favouring the French-backed idea, breaking ranks with his colleagues at the bank which have so far repeatedly rejected the idea, arguing it would be thinly disguised monetary financing of governments.
Although such a move is seen by some analysts as a game changer, bond markets remained cautious as the ESM is not even functional yet, with Germany's Constitutional Court expected to rule on it by mid-September.
Spanish 10-year yields were down 10 basis points on the day at 7.54 percent, a level deemed as unsustainable and not far away from a euro era high of about 7.75 percent.
"Markets are still angry that the ESM is not there yet," said Lloyds rate strategist Alessandro Mercuri.
Bunds accelerated their losses after a German auction of bonds maturing in 2044 was met with poor demand. German authorities were left holding a higher-than-usual 22.6 percent of the targeted amount for sale in secondary markets at a later date. See for auction details.
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 13 and 18 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." (editing by Ron Askew)