* Spanish, Italian yields fall sharply on summit measures * German Bunds slide as relief takes hold * Analysts caution more details are needed By Kirsten Donovan and Ana Nicolaci da Costa LONDON, June 29 (Reuters) - Spanish and Italian government bond yields fell sharply on Friday, and safe-haven German government debt sold off, after European Union leaders agreed a plan to allow rescue funds to be used to stabilise debt markets and directly recapitalise banks. At a summit, which continues on Friday, leaders responded to pleas from Spanish and Italian leaders to lower borrowing costs but will not force countries that comply with EU budget rules to adopt extra austerity measures or economic reforms . The moves caught markets by surprise as expectations for meaningful steps to tackle the debt crisis had all but disappeared in the run-up to the meeting. But analysts cautioned that relief could be short lived, with it unclear what exactly "stabilising" bond markets would involve. "It is one step on a very long road. To take a positive spin it's the acquiescence of Germany and ...'whatever it takes' is how it's starting to look," said Charles Diebel, head of market strategy at Lloyds Bank. "But we don't have any details and arguably the detail is where the risk lies because the market will start to pick holes in it, as we've seen previously." The leaders also agreed that the bloc's future permanent bailout fund, the European Stability Mechanism (ESM), would be able to directly recapitalise banks without this increasing a country's budget deficit, and without the ESM loans having preferential status for repayment. That is crucial for Spain which this week asked for aid for its banking sector that could total up to 100 billion euros, but analysts questioned whether the limited lending capacity of the ESM could also stretch to help bond markets. "If you take out 100 billion euros from the ESM for the Spanish bailout you have got 400 billion euros left," said Investec fixed income analyst Elisabeth Afseth. "If you then look at supporting the secondary market to drive down yields in Spain and Italy, those markets are vast. The ECB spent a significant amount to try to drive down the yields and we know that was a short-term, rather than a lasting, effect." Italian and Spanish bond yields fell sharply with shorter-dated bonds outperforming. "It's not a silver bullet and we're keeping a close eye on the details but risk-on sentiment should stay a bit longer than last time," a trader said. "It's not the end of the crisis but it's a good step forward." Italian 10-year yields were 25 basis points lower at 5.94 percent, with the Spanish equivalent down 36 bps at 6.55 percent. Traders said Spanish bonds were outperforming because more market players had held positions betting on lower prices in the paper which they were now covering. "The market is short of Spain, and traders bought Italy against it as a hedge," a second trader said. "And therefore, with Spain now tightening everyone is trying to cover their shorts in Spain and there aren't many offers," one trader said." Spanish two-year yields were 72 bps lower and Italy's down 50 basis points. The rally in riskier assets weighed on safe-haven debt with German Bund and U.S. Treasury yields both climbing but with Germany rising the most. Ten-year German yields were 12 bps higher at 1.63 percent, having briefly risen above those of their U.S. counterparts for the first time since early February. September Bund futures were 117 ticks lower at 140.54, having fallen almost two full points to 139.72 - the 50 percent retracement of the rally seen from March to May. This key support level held in early trading and Bunds are also likely to rise to fill the gap left on charts by the sharply lower opening versus last night's close, correcting some of the hefty sell-off.

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