* Spanish bond yields soar after poor auction
* ECB buying helps bond yields retreat, lifts euro
* Italy's Mario Monti outlines reforms to boost confidence (Updates prices, adds details)
NEW YORK (Frankfurt: A0DKRK - news) , Nov 17 (Reuters) - The euro edged higher from a five-week low against the dollar on Thursday after bond yields in some of the heavily indebted euro zone countries eased from extreme levels, but gains were likely short-lived on fears the debt crisis is spreading.
U.S. data showing initial jobless claims at a seven-month low last week and a smaller-than-expected fall in housing starts also boosted appetite for risk and lifted the euro.
Italian bond yields fell back below the critical 7 percent, a level widely deemed unsustainable, as Prime Minister Mario Monti unveiled sweeping reforms to dig the country out of crisis. The spread between French 10-year bond yields and German bunds also eased from record highs.
That helped the euro bounce back above $1.35 after three straight days of decline. The outlook for the common currency remains bleak, however, and it would likely resume weakness next week should the $1.36 level hold, analysts said.
"If you look at some of the PIIGS (Portugal, Italy, Ireland (Xetra: A0Q8L3 - news) , Greece and Spain) yields, they have started to become fairly negatively correlated to euro/dollar," said Ronald Simpson, managing director of global currency analysis at Action Economics in Tampa, Florida.
The euro rose 0.4 percent to $1.3517, having risen as high as $1.3539 on Reuters data. It had earlier fallen to a five-week low of $1.3420. Below there, key downside target lies near the Oct (KOSDAQ: 039200.KQ - news) . low of $1.3140.
The premium of Spanish and French bonds over German Bunds hit fresh euro era highs after poor demand at their debt sales raised fears that the euro zone crisis could spiral out of control and potentially lead to a break-up of the bloc.
Spain saw its borrowing costs rising to their highest since 1997, close to the psychologically important level of 7 percent, while Paris had to pay markedly more to sell 7 billion euros of government debt.
"The Spanish auction was really bad and yields are rising to levels where there are expectations that fresh margin calls will be imposed," said Nomura currency analyst Geoff Kendrick. "The only way to trade euro is to sell. It is headed lower and our year-end target of $1.30 looks to be tested soon."
ECB BUYING
The European Central Bank buying of Italian and Spanish debt markets before and after the debt sales helped ease some pressure on yields but looked modest in size, traders said.
Pressure has grown on the ECB to take a greater role in tackling the crisis with Paris saying it should intervene more forcefully, but Germany and the ECB itself oppose that view.
Simpson said it's key for the ECB to at least continue what it's been doing until the European Financial Stability Facility (EFSF) is finalized and in operation.
"Right now if the ECB pulled away completely from its bond buying activity, we probably would see yields go through the roof. They've been basically the only buyers."
Against the yen, the euro rose 0.3 percent to 104.01 , rebounding from a five-week low of 103.37 set Wednesday. The dollar slipped 0.1 percent at 76.96 yen .
The outlook for euro zone assets took another beating after rating agency Moody's downgraded 12 German public sector banks. Analysts said investors will shy away from the region until policymakers take more concrete and forceful actions.
"It is becoming increasingly clear that the crisis in Europe (Chicago Options: ^REURUSD - news) is unfolding like a slow-motion car crash which is odd given that largely speaking all the facts seem to be known, i.e. too much debt and a concern about it being paid back," said Dave Floyd, managing partner and head of FX trading at Aspen Trading Group, based in Bend, Oregon.
"Thus one can only assume it has been the pathetically slow and some would say half-hearted attempts by politicians to put steps in place to reassure markets that have seemingly paralyzed the markets." (Editing by Chizu Nomiyama)
