* Sale could see first ever negative 2-year auction yields * Peripheral jitters to support demand for German debt * Spain to face own market test at Thursday's auction By Emelia Sithole-Matarise LONDON, July 18 (Reuters) - Bund futures fell on Wednesday with traders cautious before a German bond auction that could see investors pay Berlin a premium for the first time ever to park their cash with it over two years. German two-year bond yields are already in negative territory in the secondary market as investors worried about the euro zone debt crisis have increasingly sought safety in the region's most liquid and top-rated assets. But this would be the first time such paper attracted a negative yield at auction. The country will sell up to 5 billion euros of zero coupon bonds, with the auction expected to find sufficient demand given persistent worries about the ability of euro zone policymakers to stop the debt crisis from engulfing Spain and Italy. "(The auction) is going to come in at negative yield. There seems to be decent demand for the paper even at these levels," a trader said. "But we've been trading sideways in the Bund all week and I don't see anything much to change that today." The Bund future was last down 14 ticks at 144.98, German 10-year yields were steady at 1.23 percent and two-year debt yielded -4 basis points, up slightly on the day. DISTORTIONS The move into negative territory in shorter-dated German yields accelerated and extended to the Netherlands after the European Central Bank earlier this month cut to zero the interest it pays banks to park cash at its overnight facility. Other top-rated euro zone issuers like France and Finland have also seen two-year debt yields fall to close to zero. "In a world where there's a zero deposit rate at the ECB, market distortions and safe-haven flows suggest that today's auction will go OK," said Charles Diebel, a strategist at Lloyds Bank. Market focus was also on Spanish and Italian debt after the Italian Prime Minister expressed "grave concerns" that the country's autonomous Sicily region may default, reminding investors the euro zone debt outlook remains gloomy. Spain may face more selling pressure in bond markets ahead of a 3 billion euro auction of paper with maturities up to seven years on Thursday. Although Madrid's borrowing costs for 12-month treasury bills fell from a month ago at an auction on Tuesday, they remained high by historic standards. Spanish 10-year yields were last 5 basis points lower at 6.78 percent with the Italian equivalent 4 bps down at 5.99 percent, with traders seeing little volume behind the moves. "There will be a fair amount of coercion for (Spanish banks)... to support the auction but we are not seeing a drift lower in yields that we need to see to get investors back. We need to see Spanish yields with a 5 percent handle not at 6 percent," Lloyds' Diebel said. "A lot of investors are very cautious," he said, recommending selling German 10-year Bunds when yields fall near 1.20 percent and buying when they rise to 1.35 percent.

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