* Euro jumps on Nowotny comments on ESM
* Analysts say move overdone, see move back to $1.2050
* High Spanish yields fan bailout concerns
By Michael Szabo
LONDON, July 25 (Reuters) - The euro rallied broadly on Wednesday, recovering from a two-year low against the dollar after a European Central Bank policymaker said he could see grounds for giving the euro zone bailout fund a banking licence.
The comments from Ewald Nowotny prompted a flurry of short-covering as the euro jumped higher, with some investors who had earlier bet against the single currency being squeezed out of those positions.
The euro hit a session high of $1.21705, up 0.9 percent on the day.
But many analysts said the move was overdone and predicted further weakness ahead.
A break below support at the psychologically important level of $1.20 would open up a test of the 2010 low of $1.1876.
"It's negativity fatigue. The market was caught short by the comments ....and Asian stops got triggered," said Steve Gallo, currency strategist at Credit Agricole, referring to stop loss buy orders in euro/dollar.
A banking licence would give the European Stability Mechanism more firepower to fight the debt crisis but analysts said the market may have put too much emphasis on the comments, given ECB opposition to date, and investors would likely sell into the euro's rally.
"The market is desperate and jumping on anything that even looks remotely positive," said Geoff Kendrick, currency strategist at Nomura.
The euro recovered from a two-year low of $1.2042 hit on trading platform EBS on Tuesday when some EU officials said Greece was unlikely to be able to pay what it owes and further debt restructuring is likely to be necessary.
But the outlook remained deeply negative given spiralling Spanish borrowing costs that have fuelled concerns the country will need a full sovereign bailout.
A 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.
Adding to concerns, the European Central Bank's latest 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.
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.
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.
Despite the bleak outlook, the euro's respite against the dollar also pushed it higher against other currencies.
Against the yen, it rose to 95.13 yen after 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.
The Australian dollar retreated from a recent record high against the euro, trading at A$1.1817 from a peak of A$1.1690 on Monday.
The Australian currency also gained against the U.S. dollar after Nowotny's comments fanned demand for perceived riskier currencies, climbing 0.6 percent to US$1.0289.
The dollar index dipped 0.4 percent to 83.641, off the previous day's two-year high of 84.10. (Additional reporting by Nia Williams; Editing by Hugh Lawson)