* Irish yields fall as EU seeks to reassure
* Italy relieves market with 8 bln euro of bond sale
* Irish banks ECB borrowing increases
(Updates to European settlement)
By Emelia Sithole-Matarise
LONDON, Nov 12 (Reuters) - Irish government bond yields fell on Friday, easing pressure on other peripheral euro zone issuers on reports Dublin was in talks to get European Union aid and that there would not be any debt restructuring tied to it.
The improved tone in the euro zone's weakling sovereign issuers stemmed the flight to safe-haven German bonds, driving the Bund future more than one percentage point down on the day to its lowest in almost two weeks.
But Irish bonds remained under heavy pressure, with 10-year yields only back around Wednesday's levels near 8.5 percent as the European Union and Ireland's finance ministry denied news reports a bailout was being hammered out.
German Chancellor Angela Merkel, speaking at the G20 summit in Seoul, said the European Union was ready to deal with all scenarios in the Irish financial crisis and, in an attempt to reassure investors, leaders said new rules concerning writedowns would only apply to future bond issues. "The rumours that the EU may come out with a support package for Ireland has led to a bout of short covering. Investors are very short Ireland," said Nick Stamenkovic, an interest rate strategist at RIA Capital Markets.
"Most of the long-term players will just be sitting on the sidelines. There's so much volatility in the market they don't want to get involved until the situation clarifies."
Dealers marked Irish bonds higher, narrowing the 10-year yield spread over Bunds to 594 basis points from Thursday's record 685 bps, although the market remained illiquid.
The Portuguese spread was 37 bps tighter at 444 bps.
Underlining the troubles Ireland's banking sector faces, Irish banks increased their borrowing at the European Central Bank by more than 10 billion euros last month.
"I don't think Ireland can survive without access to this fund," said Matteo Regesta, a strategist at BNP Paribas.
"Psychology is still for the wait and hold, and the expectation ...that by delivering the budget by the end of the year the market will endorse the fiscal consolidation and pressure will gradually fade from Irish debt, something which we don't see happening."
Spain and Italy saw 10-year yield spreads over Bunds hitting new euro lifetime highs in early trade, before retreating to stand tighter at 204 bps and 163 bps respectively.
"The widening has spilt over significantly into Spain and Italy in recent days, which will probably worry EU leaders quite a lot and they seem to be starting to realise the seriousness of the situation as the European Financial Stability Fund is designed for smaller countries," a trader said.
Lloyds TSB said Irish 10-year yields price an 80 percent chance of default, Portuguese around 65 percent and Spain 30 percent.
"The discussion of `orderly defaults' opened Pandora's box," the bank's strategists said. "The sharp rise in yields is now all about expectations of future default -- restructuring -- and not difficulties in financing."
Both the Portuguese and Irish 2/10 yield curves are close to inversion in absolute terms and in asset swap, a pattern seen earlier in the year with Greek bonds and a move that typically reflects default fears.
December Bund futures settled 77 ticks down at 129.41 with cash German bond yields rising across the board, notably Schatz yields which were up 10 bps at 1.03 percent.
Italy's bond sale went better than expected after its paper cheapened significantly heading into the sale.
"From an amount perspective, Italy weathered the storm well," said Commerzbank strategist David Schnautz.
"However, the turmoil obviously left its toll on BTPs in the run-up to the auction. Looking forward, politics should remain in the driving seat in the short term regarding the euro zone peripheral government bonds."
(Additional reporting by Paul Day; Editing by Toby Chopra)