* Questions over crisis-fighting tool favor Bund auction * Spanish, Italian yields fall on trading positioning * Spain announces new taxes and spending cuts By Ana Nicolaci da Costa LONDON, July 11 (Reuters) - A solid sale of 10-year German government bonds failed to set a clear direction for Bund futures on Wednesday, while Spanish and Italian yields fell back from highs hit earlier in the week on the view that both had gone too far. Spanish yields eased after the country's prime minister, Mariano Rajoy, announced new taxes and spending cuts aimed at improving the country's fiscal position but which could compromise desperately needed growth. Italian yields also slipped, and market players said the move was driven more by trader positioning than actual transactions. " I just think the market had oversold and we are just coming back a little bit," a trader said. Spanish yields earlier this week traded above the 7 percent level seen as unsustainable in the long run, while Italian bonds yielded more than 6 percent. "It just tells you that it's really flows-driven right now. And when I say flows not necessarily customer flows because we are not seeing much in Spain and Italy. I think it's just dealer positioning," the trader said. Trading was thin in Europe, while a bout of uncertainty regarding European attempts to overcome the euro zone debt crisis was making investors reluctant to place big market bets, a second trader said. Ten-year Spanish yields fell 14 basis points to 6.70 percent in a choppy trading session, while the Italian equivalent shed 9 bps to 5.86 percent. Italian yields showed little reaction to comments by Prime Minister Mario Monti on Tuesday that his country could be interested in tapping the euro zone's rescue fund for bond support. The comments underscored the scale of policymakers' problems in coming to grips with a crisis that is now threatening to engulf the euro zone's third largest economy, long deemed too big to be bailed out. "In my interpretation they are interested in the ESM/EFSF using their newly given flexibility/capacity to intervene in secondary markets. They would like to see the ESM or the EFSF or take over the role of the ECB," Elwin de Groot, strategist at Rabobank said. GERMAN AUCTION Germany's sale of just over 4 billion euros of 10-year bonds drew bids worth 1.5 times the amount on offer, above this year's average for similar auctions of 1.35. Demand was fueled by concerns about the effectiveness and the implementation of recently agreed crisis-fighting tools as well as by the almost 40 billion euros in German redemption and coupon payments made this week. European leaders recently agreed on a more flexible use of the euro zone rescue fund, but some of the measures have faced opposition, while Germany's top court gave no date for its verdict on complaints lodged against the European Union's bailout fund. The auction also benefited from investors seeking returns up the German yield curve after two-year yields fell into negative territory as the European Central Bank cut interest rates. "It's a combination of things here. There is an element of people being forced up the curve, but there is also an element of there isn't a lot of choice out there," said Marc Ostwald, strategist at Monument Securities. "If you have got euros where are you going to park it?" German Bund futures gained slightly after the auction results, but were last little changed on the day at 144.14 in choppy trading. Ten-year German bond yields were down 1.1 bps at 1.31 percent in secondary markets, while two-year bonds yielded -0.003 percent. Bank of Italy Governor Ignazio Visco on Wednesday backed the use of European bailout funds to stem borrowing costs for some countries, saying the spread between Italian and German bond yields was not justified by economic fundamentals. But Finland has recently opposed the use of the euro zone rescue fund for the purchase of bonds from struggling member states. Meanwhile, the fund is not considered to have enough firepower for the bulk-buying analysts deem necessary to decisively contain a rise in Spanish and Italian yields. "The moment you include Italy in anything then approval of the ESM becomes actually almost a redundant issue against (the idea that the fund) just hasn't got the firepower," Ostwald added.

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