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* Euro hits near 2-yr low vs dollar; dollar index at 20-mth high

* Focus on rising Spanish debt yields and risk of bailout (Recasts, adds quote)

By Anirban Nag

LONDON, May 30 (Reuters) - The euro bounced from near two-year lows against the dollar on Wednesday, after the European Commission called for sweeping reforms to restore investor confidence, but gains were likely to be fleeting on growing concerns about Spanish banks.

The European Commission said the euro zone should move towards a banking union and consider eurobonds and the direct recapitalisation of banks from its permanent bailout fund as it laid out year-long recommendations in a report.

The euro rose to as high as $1.24684 from a 23-month low of $1.24241 on trading platform EBS after the comments, but analysts said any bounce would only provide a fresh opportunity to sell the common currency.

"We will sell into this bounce as these proposals will take a long time and will entail changes to the treaty," said Geoffrey Yu, currency strategist at UBS.

Earlier the euro fell to its lowest since early July 2010, as real money and institutional investors stepped up sales of the currency. Their selling gathered pace as concerns grew about Spain's ailing banking sector and soaring borrowing costs, and after Italy was forced to pay dearly to sell debt.

The euro was seen highly vulnerable to further falls, with many analysts looking for a drop towards $1.20.

Concerns are growing that Spain may have to tap debt markets at a time when bond yields are near unsustainable levels. Market players fretted that it may be forced to seek an international bailout.

Adding to the euro's woes, Italian 10-year government bond yields topped 6 percent as sentiment on the indebted economy looked vulnerable to contagion from Spain's worsening problems.

"The euro is in an extremely vulnerable position and downside risks are very strong indeed ... The Spanish banking crisis has the potential to knock the stuffing out of the euro zone irrespective of the Greek election results," said Jane Foley, senior currency strategist at Rabobank.

"The issues for Spain are undoubtedly huge and most people are coming round to the idea that it will need to go outside of its borders for assistance. The longer it delays, the more the risk of a bank run."

More falls could see the euro test a reported options barrier at $1.2400. Below there it has little chart support until $1.2151, a low hit in late June 2010, and then the 2010 low of $1.1876.

The common currency also lost more than 1 percent against the safe-haven yen, taking it to a four-month low of 98.274 yen. It recovered to trade at 98.425 yen, still down 0.9 percent on the day.

DOLLAR BUOYANT

A government source told Reuters on Tuesday that Spain would likely recapitalise Bankia, which asked for 19 billion euros on Friday, by issuing new debt and possibly drawing cash from the bank restructuring fund and Treasury reserves.

The euro's weakness benefited the safe-haven dollar and yen, helping the dollar index, which measures its value against a basket of currencies, rise to a 20-month high of 82.749.

Technical analysts said a monthly close about the 100-month average in the dollar index around 81.82 may herald a shift in the longer-term trend of the dollar and reverse a multi-year drift lower.

The dollar also rose to a 15-month high against the Swiss franc at 0.9666 francs on EBS.

The higher-yielding Australian dollar fell 0.7 percent to $0.9777, slipping towards a six-month low at $0.9690, after weaker-than-expected retail sales data underscored the case for interest rate cuts. (Additional reporting by Jessica Mortimer; Editing by Andrew Roche)

* Such bets likely to accumulate in coming days

* As in May, markets could set themselves up for letdown

By Marius Zaharia

LONDON, May 30 (Reuters) - Bets that the ECB will cut interest rates next week are again appearing in money markets, as Spanish and Italian debt yields are approaching levels that made the central bank introduce unprecedented easing measures last year.

The threat that Greece could eventually leave the euro and worries over Spain's banking sector have prompted investors to sell Spanish and Italian debt, bringing the two countries' borrowing costs closer to levels deemed as unsustainable.

The sheer size of their debt markets and their deep-rooted connections with other financial systems in the euro zone are reasons for investors to speculate that a policy response is in the works.

The European Central Bank is, as usual, seen as the most likely institution to take measures to cool market nerves because it can act faster than politicians. It has done it before in the past by injecting around 1 trillion euros of cheap loans into financial system in December and February.

Euro zone economic data this month has also been poor, supporting bets that the ECB may soon resume monetary easing, possibly by cutting its key refinancing rate by 25 basis points from a record low of 1 percent.

"Data ... have been softer, and then you have the Greece issue continuing to be unresolved and the Spanish issue continuing to be unresolved," said Elaine Lin, a rate strategist at Morgan Stanley, whose economists predict a rate cut.

She said the euro overnight Eonia rate forward market was only pricing an over 10 percent probability of a rate cut in June and the chances were higher by another 10-20 percentage points for the July meeting. However, she expected markets to factor in a higher probability in the next few days.

A key rate cut, if also accompanied by a cut in the 25 basis points deposit facility rate, could trigger a 5-10 bps fall in the near-term forward Eonia rates towards the 20 bps level seen now in September-October Eonia forward rates, Lin said.

The lowest point on the 2012 Eonia curve is December, at 16 basis points, which implies an 80 percent probability that the deposit rate would be slashed in half, according to BNP Paribas rate strategist Matteo Regesta.

A Reuters poll of economists showed the ECB was likely to resist pressure to cut interest rates in June, but also pointed to a growing probability that it will reduce them later this year.

Speculation about ECB monetary easing has also been fuelling a rally in Euribor futures , implying bets for lower fixings of benchmark euro zone interbank three-month Euribor rates later this year.

The December Euribor future has gained back most of its losses made since Greece's inconclusive election on May 6, which sparked fears the country may be on its way out of the bloc. The fall earlier this month also coincided with unwinding bets that the ECB would have cut rates in May.

The contract was last 3.5 ticks higher on the day at 99.46. That was one tick lower than the pre-election close on May 4, but some 15 ticks higher from the lows hit in mid-May.

The move higher in Euribor futures, which has been faster than the move lower seen in the very low Eonia forward rates, has led to tighter Euribor/Eonia spreads, which are widely used as a gauge of money market stress.

That is counter to what is happening in banking credit default swap markets - where investors can insure against banking defaults. The Markit iTraxx index of European senior financials CDS remains close to its highest level this year at around 300 bps.

BNP Paribas' Regesta warned that Euribor futures could fall again as they have done after the ECB's May meeting and this would trigger a widening of the Euribor/Eonia spreads consistent with the levels of stress felt in money markets.

"You have a decoupling between those spreads and the banks CDS now, but those spreads remain exposed to significant paying interest in coming weeks ... unless there is another policy response from the ECB at its meeting next week," Regesta said.