* Bunds rally, supported by worries over U.S., euro zone debt * Germany adds to implementation worries over Greece rescue * Italy sells index-linked bonds, readies for Thurs BTP auction By Kirsten Donovan LONDON , July 27 (Reuters) - German government bonds rose on Wednesday, supported by doubts over whether measures to stem the euro zone debt crisis were enough to stop contagion to the region's larger economies and by the deadlock in talks on raising the U.S. borrowing limit. Although U.S. Treasuries have held up relatively well -- helped by the size of the market and widespread holdings -- risk assets have come under pressure on worries the United States may lose its triple-A credit rating even if a last-minute deal to avoid a default is hammered out. "After a downgrade, Treasuries would sell off, with a move likely to be nearer 50 basis points than zero," said ING rate strategist Padhraic Garvey. "That would be a knee-jerk reaction and there'd be a flow into Bunds, so the German/U.S. spread would widen by at least that amount or more." But Garvey said any sell-off would be short-lived with Treasuries soon trading on U.S. growth and economic fundamentals rather than the credit rating, much like Japanese government bonds, which are rated in the double-A bracket. "It won't change the fact that Treasuries are a global benchmark and the dollar a global reserve currency, the trade flows will dictate what you have to hold." Deeply divided Republican and Democratic leaders are scrambling to find common ground with less than a week before the government hits its borrowing limit approved by Congress, triggering a possible default that would rock global markets. Serious discussions look to be delayed for several days after Republicans pushed back a House of Representatives vote on their plan originally expected for Wednesday. The spread between 10-year Bunds and higher-yielding U.S. Treasuries has widened more than 20 basis points over the last month to 26 basis points as Bunds have outperformed. September Bund futures were 57 ticks higher at 128.91, having hit a session high of 129.07. Ten-year German yields were 4.5 bps lower at 2.69 percent. Futures broke above 128.45 -- the 62 percent retracement of last week's sell off -- in early trade, to test the 76 percent retracement at 128.94. Last week's plan to help Greece and stem contagion to other euro zone states provided only limited relief to markets. Bunds as well as Spanish and Italian bond yields are back around levels seen before details of the rescue plan were leaked. "Lack of detail and implementation risks (for the Greek package), as well as the U.S. debt ceiling debate nearing its deadline should keep markets tending towards 'risk off' mode today," Commerzbank rate strategist Benjamin Schroeder said. German Finance Minister Wolfgang Schaeuble said Berlin was against giving the euro zone's rescue fund carte blanche to buy bonds on the secondary market while Slovakia's junior government party has said it is against increasing the size of the bailout fund . Spanish 10-year bond yields were 7 bps higher at 6.04 percent, with equivalent Italian yields up 13 bps at 5.77 percent. Italy sold 942 million euros of euro zone index-linked bonds, the second of three sales totalling around 10 billion euros this week with yields up more than 150 basis points from the previous sale in May. "The increase in yield...is larger than that observed in the same period on nominal bonds of the same maturity because...in times of market stress, investors prefer to hold nominal bonds...because (they) have a larger cash flow at maturity," said UniCredit rate strategist Chiara Cremonesi. But the main test of market appetite this week comes on Thursday with a 6.5 billion euro three- and 10-year BTP sale. Credit Agricole rate strategist Peter Chatwell said the auction should find support from Italian redemption cash flows on Aug. 1, and large index extensions generating demand for longer-dated paper. "I expect the BTP auctions to find sufficient demand tomorrow, but trading will be very nervous ahead of the sale, Chatwell said. "There is probably still too much uncertainty surrounding the euro zone debt crisis and U.S. debt ceiling saga for the auctions to be strong." But one trader said it was wrong to gauge market sentiment from auction results. "The market perception of auctions as a test of sentiment is wrong as the primary dealers have a gun to their head to take down the paper," the trader said. (Reporting by Kirsten Donovan)

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