* Euro spikes higher after Nowotny comments on ESM
* Analysts see more weakness ahead, test of $1.20
* High Spanish yields fan bailout concerns
By Nia Williams
LONDON, July 25 (Reuters) - The euro recovered from a two-year low against the dollar on Wednesday, jumping sharply higher on comments from European Central Bank policymaker Ewald Nowotny that he could see grounds for giving the euro zone bailout fund a banking licence.
Analysts said such a move would give the European Stability Mechanism more firepower to fight the debt crisis, but the market may have put too much emphasis on the comments, given ECB opposition to date, and investors were likely to sell into the euro's spike higher.
The outlook for the euro remained deeply negative given spiralling Spanish borrowing costs that have fuelled concerns the country will need a full sovereign bailout.
Some market players said was likely to break below support at the psychologically important $1.20 level in coming days. That would open the door to a test of the 2010 low of $1.1876.
"The market is desperate and jumping on anything that even looks remotely positive. The squeeze higher will fade now and we'll probably print a fresh negative later on today," said Geoff Kendrick, currency strategist at Nomura.
The euro rose 0.5 percent to hit a session high of $1.2128. Traders said an Asian central bank and macro funds had earlier sold into euro strength.
It remained within sight of a two-year low of $1.2040 hit on Tuesday after some EU officials said Greece is unlikely to be able to pay what it owes and further debt restructuring is likely to be necessary.
A slightly worse-than-expected German business climate index ate into some of the single currency's gains, adding to concerns activity in the euro zone's largest economy is slowing down.
A European Central Bank lending survey found banks made it harder for firms to borrow in the second quarter and expected to see a slump in demand as the euro zone debt crisis deepened.
But the euro also regained ground against the yen after the Nowotny comments, rising 0.5 percent to 94.80 yen, having carved out a new 12-year low of around 94.12 yen earlier in the week. Traders in Tokyo cited talk of a euro/yen option barrier at 94.00 and stop-loss offers under the level.
Spain paid the second highest yield on short-term debt since the birth of the euro at an auction of three- and six-month bills on Tuesday, indicating difficulties in future debt sales.
Yields on Spanish debt have jumped since last week when the region of Valencia said it would need financial help from Madrid, with investors concerned other indebted regions will also seek aid.
"Borrowing costs in Spain have already reached unsustainable levels and the price action in the euro suggests that investors believe it should only be a matter of time before there is a need for a sovereign bailout," said Kathy Lien, managing director of FX strategy for BK Asset Management.
Delivering yet more bad news for Europe, Moody's changed the outlook on its provisional top-notch rating for the European Financial Stability Facility to negative.
The action was expected given its move earlier in the week to put a negative outlook on Germany, the Netherlands and Luxembourg.
The Australian dollar retreated from a recent record high against the euro, trading at A$1.1796 from a peak of A$1.1690 on Monday.
It gained against the U.S. dollar however after Nowotny's comment fanned demand for perceived riskier currencies, climbing 0.4 percent to US$1.0257.
The dollar index dipped 0.3 percent to 83.772, off the previous day's two-year high of 84.10. (Additional reporting by Antoni Slodkowski. Editing by Jeremy Gaunt.)