FOREX NEW YORK COMPANIES

* Italian rates rise but market still functioning

* Interbank cash rates fall on rate cut expectations

By Kirsten Donovan

LONDON, June 18 (Reuters) - A lack of available Spanish government bonds, due to so many being used to obtain funding at the European Central Bank, is distorting pricing in repo markets and causing investors headaches as they seek to cover hefty short positions.

As international investors sold Spanish government bonds this year, domestic banks bought them and parked them at the ECB in return for funds - particularly during the two recent three-year funding operations.

As a result, investors who need the bonds because of their own short positions must pay a premium for the paper.

When this happens in repo markets - where banks commonly use government bonds as collateral to raise funding - bonds are said to be trading "special".

Effectively, the investor who needs the bonds pays a premium to their counterparty in the trade - the opposite of a typical repo trade where the party borrowing cash pays the premium.

"There's some good evidence of a collateral shortage out there," said ICAP rate strategist Chris Clark. "Quite a lot may be being used at the ECB and the market short (positions) out there will be increasing the demand for specific bonds."

It is the opposite of what might be expected when a country's debt comes under pressure. Then counterparties are usually more reluctant to be left holding the bonds.

"The collateral just isn't there. That's one of the problems and the few bonds that are still available are highly sought after by people who want to cover their short positions," said Commerzbank rate strategist Benjamin Schroeder.

Ten-year Spanish government bond yields have risen more than 130 basis points since the start of May, while two-year yields are up over 2 percentage points.

That prompted international clearing house LCH.Clearnet SA to increase the cost of using Spanish bonds to raise funds via its repo service last month. Analysts said their trading desks had since seen volumes over the platform drop.

"It's a further segregation of European money markets, where banks are retreating from central clearing houses and going back to domestic clearing or bilateral agreements," Schroeder said.

As the euro zone debt crisis intensified this month, mainly due to worries about Spain's banking sector, Italian general collateral (GC) repo rates, paid to borrow funds against a basket of government bonds, have been pushed higher.

There is little trade in the Spanish general collateral market but banks are still able to borrow using Italian bonds as collateral, despite Italy being seen as vulnerable to contagion from worries about Spain.

Three-month Italian GC rates rose to 0.42 percent at the end of last week, compared to the Eonia overnight rate at around 30 basis points, according to ICAP. The Italian rate had traded below Eonia from the time of the ECB's second three-year funding operation at the end of February until the end of May.

"There's been a rise in Italian general collateral rates, both outright and relative to the Eonia OIS curve," ICAP's Clark said. "Despite a reduction in the amount of term activity that goes on, the Italian market is still very much functional."

RATE SPECULATION

Three-month Euribor interbank lending rates eased again, hitting their lowest since the second quarter of 2010 as speculation grew the ECB may cut interest rates.

ECB president Mario Draghi heightened expectations the bank could cut interest rates or take further policy action soon after saying on Friday that the euro zone economy faced serious risks and no inflation threat.

September and December Euribor futures contracts rallied to contract highs, pushing implied rates lower.

Markets are pricing in a 50 percent chance of a 12.5 basis point cut in the ECB's 0.25 percent deposit rate this year, and a 25 percent of the rate being cut to zero, according to RBS.

* Greek bounce short-lived; Spain, Italy fears dominate

* Spanish 10-year bond yields rise above 7 pct

* Euro seen a sell into any bounce

By Gertrude Chavez-Dreyfuss

NEW YORK, June 18 (Reuters) - The euro fell from a one-month high against the dollar on Monday after four days of gains, as an election win for pro-bailout parties in Greece faled to ease worrries about Spain's borrowing costs, which surged to levels seen as unsustainable.

While the election result allayed immediate fears of Greece being forced out of the euro zone, uncertainty persisted as the winning centre-right New Democracy party must now try to cobble together a government with other parties backing the international bailout.

Antonio Samaras, the New Democracy leader, on Monday, said the country needed as broad a coalition government as possible, after radical leftist refused to join.

Market players were also concerned about the euro zone's ability to respond to the risk of contagion engulfing larger economies like Spain and Italy. All of which is likely to see investors sell into any near-term bounce by the euro.

"The win in Greece does not really resolve anything. It's still going to be tough for Greece," said Boris Schlossberg, managing director ar investment advisory firm BK Asset Management in New York.

"And with Spanish and Italian yields at high levels, the credit market remained skeptical that Europe is going to get out of the debt crisis."

The euro was down 0.1 percent on the day at $1.2619, off a one-month high of $1.2747 struck in the Asian session, as it came under pressure on reported selling by Asian sovereign investors.

It fell past reported stop-loss orders around $1.2660-70 to $1.2620 in the European session with support expected around the June 13 high of $1.2610.

Ten-year Spanish government bond yields, hit by persistent concern about the country's fiscal and banking problems, rose above the 7 percent line seen as unsustainable in the long-term and at a level that forced other peripheral euro zone nations to seek bailouts.

Despite the problems facing the bloc, some strategists saw potential for the euro to rise given a build-up of huge bearish positions in the common currency, taken on concerns that a win for anti-bailout parties could lead to Greece rejecting austerity measures and leaving the euro.

"In the short term, a short squeeze or speculation about quantitative easing by the Federal Reserve could give the euro a lift, but in the medium term it is a sell because Europe's problems are deep-rooted and will not go away," said Howard Jones, adviser at RMG Wealth Management.

"Any rebound to around $1.2800 is a selling opportunity."

Positioning data showed speculators' massive net short positions of 195,187 contracts last week, even after having trimmed them from the previous week's record high of 214,418 contracts.

Fund of funds Quaesta Capital in Zurich Switzerland, which manages $3 billion in assets, saw euro shorts among its fund managers continuing to be one of the biggest positions last week, along with bets against the Swiss franc.

Interestingly, the U.S. dollar showed the largest outflow last week in the portfolios of the fund managers Quaesta tracks, while the Canadian currency showed the biggest inflow last week.

FED QE RISK MAY HELP EURO

In the options market, near-term implied volatilities fell, with the one-week easing to 11.45 percent from a high of around 16.75 percent last Thursday, while the one-month fell to a roughly four-week low of 11.26 percent.

However, one-month risk reversals pointed to a bias for euro weakness.

European finance ministers meet on Friday and a summit is scheduled for the end of this month, but little is expected in the way of fresh policy measures towards a banking union or greater fiscal integration like common eurobonds.

Traders expect some volatility in the currency market in coming days. The common currency could benefit versus the dollar on speculation that the U.S. Federal Reserve may opt for more easing to boost growth.

Many market players expect the Fed to extend its long-term bond-buying through Operation Twist by a few months from the current deadline of June, after a series of disappointing data. Additional easing by the Fed could also support other perceived riskier currencies against the greenback.

The dollar index was up 0.3 prcent at 81.845 after hitting a one-month low of 81.266. The Australian dollar was down 0.1 percent at US$1.0067, off a one-month high of US$1.0135.

The safe-haven yen fell against the euro, which rose 0.3 percent to 99.76 yen, while the dollar advanced 0.5 percent at 79.12 as a result of the initial risk-positive reaction to the Greek vote.