LONDON, Aug 22 (Reuters) - German government bonds rose on Wednesday as a rally in risk assets paused, but gains were seen limited in the short term with expectations of European Central Bank action to contain the euro zone crisis firmly entrenched.
The improvement in risk appetite in recent weeks led to a fall in demand at the sale of a new German two-year bond, with the number of bids relative to the amount on offer coming in at their lowest level this year.
European equities fell and Spanish and Italian bond yields were more or less flat after falling sharply in recent weeks.
The ECB is expected to buy struggling countries' debt, with speculation increasing -- despite attempts by the ECB to quash such talk -- after a German magazine said the bank was examining plans which would cap interest rates for Spain and Italy.
"The sell-off has been very sharp in Bunds given there are important events coming up in September," said ING rate strategist Alessandro Giansanti.
"We can have some days of recovery in the market and a further rally but we are unlikely to go back to the best levels without more negative news -- either the ECB does not buy bonds or Greece does not get more money."
September is likely to prove a decisive month for market direction with the ECB's next policy meeting on the 6th, followed by a German constitutional court vote to ratify the euro zone rescue fund and a European finance ministers meeting.
But it is not just Spain which could unsettle markets.
Greek Prime Minister Antonis Samaras -- facing a sovereign bankruptcy without further aid -- begins a European charm offensive to persuade euro zone leaders to give his country more time push through unpopular reforms.
German Bund futures were 66 ticks higher at 141.04, having risen as high as 142.27 in early trade.
The contract had sold off as much as 5.5 points over the last six weeks and has since struggled to rise back above 142. Technical analysts see 142.22 - the mid-point of the last week and a half's sell-off - as the next major resistance level which needs to be overcome if the rally is to continue.
Ten-year yields were six basis points lower at 1.51 percent.
Traders said investors were also buying slightly higher yielding, but still relatively safe assets such as French bonds.
"The event risk starts to increase as soon as you get into September but if you look at someone like France, there's a window of a couple of weeks before their next issuance and we're seeing some buying there," one trader said.
The summer lull in primary market issuance has also helped calm peripheral markets and lessened the safe-haven allure of Bunds but next week Italy will return to the market on Thursday.
"The Italian supply is looming and there is a UK holiday on Monday," a second trader said.
"What we've seen in previous short weeks is that doesn't leave much time for dealers to set up their short positions and the concession gets built in very late, which may weigh on the periphery, and so we could see Bunds rising, maybe even another full point into the auction."
Dealers generally sell bonds before auctions to cheapen the new issue and make room for it on their books -- so-called concession building.
The buying of Spanish bonds seen on Tuesday had tapered off, the traders said, but Italian domestic investors were still buying their sovereign's bonds in the 4-7 year maturities.
Germany sold 4.08 billion euros of new September 2014 bonds, its second two-year issue to pay no interest to investors.
Demand for the low-risk liquid paper was still solid given the lack of clarity on any action the ECB may take but notably lower than at other similar sales this year.
"The fact that it came at a zero rate still shows that despite the improvement in risk appetite recently, investors are still concerned (about the euro zone debt crisis)," said Nick Stamenkovic, rate strategist at RIA Capital Markets.
