* Bunds rally with sell-off seen overdone * Further rises possible but no return to highs yet * Germany to sell 5 bln euros of new two-year bonds By Kirsten Donovan LONDON, Aug 22 (Reuters) - German government bonds rose on Wednesday as a rally in risk assets paused, but gains were seen limited in the short term with expectations of European Central Bank action to contain the euro zone crisis firmly entrenched. European equities fell, tracking an overnight retreat by the U.S. S&P 500 index from four-year highs hit on optimism the ECB will act to lower Spanish and Italian borrowing costs. Spanish and Italian bond yields were flat or slightly higher after falling in recent days. The ECB is expected to buy struggling countries' debt, with speculation increasing -- despite attempts by the ECB to quash such talk -- after a German magazine said the bank was examining plans which would cap interest rates for Spain and Italy. "The sell-off has been very sharp in Bunds given there are important events coming up in September," said ING rate strategist Alessandro Giansanti. "We can have some days of recovery in the market and a further rally but we are unlikely to go back to the best levels without more negative news -- either the ECB does not buy bonds or Greece does not get more money." September is likely to prove a decisive month for market direction with the ECB's next policy meeting on the 6th, while the German constitutional court votes to ratify the euro zone rescue fund six days later. European finance ministers meet on Sept. 14 and 15. But it is not just Spain which could unsettle markets. Greek Prime Minister Antonis Samaras -- faced with a sovereign bankruptcy without further aid -- begins a European charm offensive to persuade euro zone leaders to give his country more time push through unpopular reforms . German Bund futures were 60 ticks higher at 141.98, having risen as high as 142.27 in early trade. The contract had sold off as much as 5.5 points over the last six weeks and has since struggled to rise back above 142. Technical analysts see 142.22 - the mid-point of the last week and a half's sell-off - as the next major resistance level which needs to be overcome if the rally is to continue. The summer lull in primary market issuance has also helped calm peripheral markets and lessened the safe-haven allure of Bunds but next week Italy will return to the market on Thursday. "The Italian supply is looming and there is a UK holiday on Monday," a trader said. "What we've seen in previous short weeks is that doesn't leave much time for dealers to set up their short positions and the concession gets built in very late, which may weigh on the periphery, and so we could see Bunds rising, maybe even another full point into the auction." Dealers generally sell bonds before auctions to cheapen the new issue and make room for it on their books -- so-called concession building. Germany will sell 5 billion euros of a new September 2014 bond on Wednesday, its second two-year issue to pay no interest to investors, with demand for low-risk liquid paper still high given the lack of clarity on any action the ECB may take. "The ECB should find it difficult to top already increased expectations at its September meeting ... today's Schatz auction should provide a good opportunity to park some cash ... ahead of likely volatile September weeks," Commerzbank strategists said in a note.

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