* Spanish yields fall as Spain edges towards aid request * Italy lags after growth downgrade * Bunds fall against better market tone By Kirsten Donovan LONDON, Sept 21 (Reuters) - Spanish government bond yields fell and German Bunds dipped on Friday with speculation growing Spain may soon request a bailout, but uncertainty over the timing contained the moves. There were signs on Friday that Spain was slowly moving towards requesting financial assistance with sources telling Reuters that the country was considering further spending cuts to meet the conditions of the expected aid package. Spanish 10-year government bond yields were 3 basis points lower at 5.78 percent but there were still doubts over when, or even if, Spain would ask for aid. While an announcement could be made next week when the government adopts the first draft of the 2013 budget, EU officials close to the discussion said they did not expect Madrid to seek an assistance programme before the Oct. 21 regional vote in Galicia. "There's no doubt talks are going on behind the scenes," said ING's head of investment grade strategy Padhraic Garvey. "But the longer Spain takes, the greater the risk we see a sell-off in the meantime and the fact is, we're still waiting." Traders said peripheral bond markets had become more illiquid again after market players had "done what they had to do" after the ECB unveiled its bond-buying plans. The difference in price between what buyers are willing to pay for Spanish bonds and what sellers will sell at - a measure that tends to widen as market liquidity shrinks - was at 90 cents, the most in a month. "The markets aren't particularly active," one trader said. "It's not even really a risk-off scenario today, more a bit of a reversal of some of yesterday's moves." Garvey said although clients had covered some of their short positions in recent weeks, referring to unwinding bets that peripheral government bond prices were going to fall, very few fund managers were taking on long positions; rather many were back on the sidelines. Italian bonds underperformed their Spanish counterparts - with yields up around a basis point across the curve - after the Italian government slashed growth forecasts and said its debt-to-GDP ratio in 2012 would hit its highest level on record, despite harsh austerity measures. "There's a chance BTPs come under pressure, especially with a decent chunk of supply coming up next week," another trader said, although he added that if Spanish bonds rallied, the better tone in the periphery would help Italian paper. Italy will sell zero-coupon and inflation-linked bonds on Tuesday, followed by medium- and long-term bonds on Thursday. Details will be announced on Friday and Monday respectively. December Bund futures were 40 ticks lower at 139.81 after rallying this week on doubts over Spain's willingness to ask for aid, a necessary step to enable the European Central Bank to buy its bonds. "We tested a small support channel around 139.70," a third trader said. "But we really need to go below 139.50 to see them start to slide again." The traders anticipated a relatively quiet end to the week. "The positioning seems to be pretty square now, with the obvious trades around the ECB and Federal Reserve action done," the second trader said. "There's a bit of head scratching now over what to do next." The support for Bunds seen this week related to a slew of corporate bond issuers entering into interest rate swap agreements, and this also slowed on Friday.

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