* ECB bank funding round disappoints
* Dampens speculation for potential carry trades
* Italian short-dated bonds lead sell-off
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Adds analyst comment, Bank of England policy decision, auction results)
By Dhara Ranasinghe
LONDON, Sept 19 (Reuters) - Short-dated Italian government bonds sold off on Thursday after the take-up of long-term loans by banks at the European Central Bank's latest funding round fell short of expectations.
Euro zone banks took up just 3.4 billion euros worth of long-term loans from the ECB, an unexpectedly low figure which is just a fraction of how much banks repaid to the ECB earlier this week.
There had been talk that banks would flock to the ECB loans and use them to snap up higher-yielding peripheral government bonds in so-called "carry trades". Italy tends to be the main beneficiary of such trades because of its higher yields, analysts said.
But this speculation was dampened by the results of the funding round, sparking a modest sell-off in bond markets already on the back foot after the U.S. Federal Reserve on Wednesday cut rates but dashed hopes of further easing.
"There was disappointment at the allotment in the latest round of ECB loans and this challenges speculation about a potential boost to peripheral carry trades," said Richard McGuire, head of rates at Rabobank in London.
Italy's two-year bond yield rose to as high as -0.18% , before pulling back to -0.21% -- still up 3 basis points on the day.
Yields across the Italian curve were up to 3 bps higher, underperforming other euro zone bond markets.
"We see several reasons for this very low take-up (of loans), but the bottom line is that most banks are likely to wait for the next operation in December," said Frederik Ducrozet, a strategist at Pictet Wealth Management.
"The ECB's two-tier (rate) system should have been an important driver of banks' demand for term liquidity ... especially in Italy where banks will have about 30 billion euros in unused exempted reserves that they could use to arbitrage the rates differential between TLTROs and the ECB's tiered rates."
The ECB last week cut rate, unveiled open-ended asset purchases and introduced a tiered rate system to mitigate the negative side effects of sub-zero rates on banks. This system takes effect from Oct. 30.
Analysts are waiting to see what take-up will look like in the next operation.
Take-up "will most likely be bigger (than today) but how much bigger and whether it is going to be big enough to offset TLTRO II (repayments) is not a given," said ING senior rates strategist Antoine Bouvet.