* Bunds sell-off, rally in Italian, Spanish bonds slowing * Soothing words from policymakers help Italian debt sale * Markets want action to follow words before rallying more By Marius Zaharia LONDON, July 30 (Reuters) - A rally in Italian and Spanish government bonds showed signs of exhaustion on Monday as investors waited for European policymakers to back up their pledges to safeguard the euro with new anti-crisis measures. Italy's borrowing costs fell at a debt sale, but remained elevated in a sign that caution was setting in after the hype created by last week's comments from European Central Bank President Mario Draghi that the ECB would do whatever it takes to preserve the euro. Draghi's words fuelled speculation the ECB would resume its bond-buying programme (SMP)-- opposed by Germany's Bundesbank -- in the near term or possibly ease monetary policy further at its Thursday meeting. However, some analysts say the bank may explore new policy tools, such as outright asset purchases. Officials have said the ECB and national central banks are considering taking significant losses on their Greek bond holdings, in another sign that measures previously considered taboo are being contemplated behind the scenes. "(Draghi) has upped the stakes massively," said Peter Allwright, head of absolute return on rates and currency at RWC Partners. "He has gone all in, but the market will be calling his bluff." The nature and timing of any action is unclear and euro zone officials have said September is shaping up to be a "make-or-break" month in the search for a resolution to the three-year-old debt crisis Spanish 10-year yields dropped 13 basis points to 6.64 percent, having fallen from levels around 7.5 percent seen before Draghi's comments on Thursday. Italian 10-year yields were 6 basis points higher at 5.88 percent. "If they really wanted to bring down yields in the secondary market we will need to see an intervention this week, considering the strong statements that we've had over the past couple of days," Investec fixed income analyst Brian Barry said. German Bund futures were seven ticks higher at 143.28. Ten-year German yields were little changed at 1.39 percent, while two-year yields were 6 basis points lower at minus 0.08 percent. RWC's Allwright said he favoured short-dated German paper going into the ECB meeting as it would benefit from any outcome. A disappointment would reignite safe-haven flows, while more monetary easing would support a further drop in short-term rates. TIME-BUYING The markets' main concern, that Spain may need a sovereign rescue, is still unaddressed. A euro zone official said Economy Minister Luis de Guindos had brought up the prospect of a 300 billion euro bailout last week at a meeting with German Finance Minister Wolfgang Schaeuble. Spain denied this was the case. A Spanish bailout would use up the euro zone's resources for fighting the debt crisis and leave Italy, seen as the next potential domino after Spain, unprotected. ECB bond purchases are likely to be of little use in such a situation. "It's just time-buying," Lloyds rate strategist Eric Wand said. "They (the ECB) may take us through to September ... but the ECB action really needs to be supported by some other stabilisation measures at EU level." In the meantime, however, Wand said the market was building expectations of some form of ECB intervention: "The nature of Draghi's language was quite forceful so I would expect them to act. The reaction could be quite ugly if they didn't." The comments from euro zone policymakers did, however, help Italy to sell 5.48 billion euros of bonds at lower yields compared with previous sales. "Despite the welcome dip in yields, though, Italy's cost of borrowing remains decidedly elevated and perhaps indicative of residual market caution heading into Thursday's ECB policy meeting," Rabobank strategist Richard McGuire said. "While these sales do provide some indication of an easing of tensions at the periphery, they also show considerable further progress on this front is needed."

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