* Spanish yields fall sharply, five-year now below 7 percent * Draghi says ECB ready to do what it takes to protect euro * Bunds fall sharply as Draghi fuels demand for risk By Ana Nicolaci da Costa LONDON, July 26 (Reuters) - Spanish and Italian government bond yields fell sharply on Thursday after comments by European Central Bank President Mario Draghi fueled expectations that the central bank may be ready to take bolder action to combat a three-year old crisis. Draghi pledged on Thursday to do whatever was necessary to protect the euro zone from collapse, including fighting unreasonably high government borrowing costs, also knocking the German Bund future sharply lower. Analysts have been weighing up the appeal of safe-haven debt in times of crisis with the expectation that any outcome would cost Germany dear. This has left Bunds volatile even though they were still near historical highs. The comments come ahead of an ECB monetary policy meeting next week and one day after ECB policymaker Ewald Nowotny was reported saying that giving Europe's permanent rescue fund a banking licence to boost its firepower had merits. "It has been a market mover suggesting that the ECB could be a bit closer to a policy response than apparently the market thought before," Rainer Guntermann, strategist at Commerzbank said. "I doubt the expectation for another rate cut would have triggered this kind of market response," he said. The expectation is for "something bolder than that, SMP-style intervention (bond-buying) or liquidity measures." Draghi's comments provided peripheral markets with much needed relief, taking some pressure off Spain's borrowing costs whose rise this week sparked concerns about the country's ability to fund itself in the market. Ten-year Spanish government bond yields fell 31 basis points to 7.1 percent, five-year Spanish yields fell below the 7 percent danger mark to 6.82 percent, and two-year bond yields eased 60 basis points to 5.66 percent. Earlier this week, shorter-dated Spanish yields rose faster than their longer-dated counterparts, briefly inverting the yield curve between the five - and 30-year sector. Italian yields also fell sharply, especially in the short-part of the curve. Ten-year yields were down 30 bps at 6.15 percent, five-year yields shed 44 bps to 5.68 percent and two-year yields were 55 bps lower at 4.44 percent. GERMANY'S CATCH-22 German Bunds also fell sharply after Draghi's comments benefited riskier assets and as investors contemplated the costs to Germany of any outcome to the crisis. A warning on Germany's credit rating this week was a reminder of its vulnerability to the regional problems that are also beginning to take a toll on its export-led economy. Steps towards a crisis-resolution is likely to see investors re-evaluate Germany's current yield levels which are near record lows and in the two-year sector is even negative. German 10-year bonds last yielded 1.31 percent, up 4 basis points on the day. Sergio Capaldi, strategist at Intesa SanPaolo, said Bunds should continue to benefit from safe-haven flows and 10-year yields could fall as far as 1 percent. Without safe-haven flows into German debt, 10-year yields would probably stand around 2.2 percent, Capaldi said before Draghi began to speak. "The Bund and also the Treasury (U.S. note future) are mainly overvalued but of course this is the effect of flight-to-quality in Europe and in the U.S., it's the combination of flight to quality and Fed intervention," Capaldi said. "Until these two phenomenon do not peter out, probably these levels are sustainable in the medium term." Bund futures were 56 ticks lower on the day at 144.13, having seen choppy early morning trading in thin liquidity. "It's thin, it doesn't take much to move stuff. A lot of people are away, much of that could get worse over the Olympics. Volatility could increase and volumes could go down in the next couple of weeks quite notably," one trader said.

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