Investors hedge bond bets before Italy vote, banks rebound

* Monte dei Paschi leads share bounce back, up 16 pct

* ECB ready to buy more Italian bonds - sources

* BlackRock says upping exposure to Europe's banks

* Firm demand at auction shows investors hedging bets

* Graphic on 'colossal' Italy shorts: http://reut.rs/2fLW0lO

* Chance of Italy exiting euro zone rising -survey (Updates with ECB story, quote)

By John Geddie and Dhara Ranasinghe

LONDON, Nov 29 (Reuters) - Italy's borrowing costs were set for their biggest fall in two weeks on Tuesday as bank shares recovered from recent falls and sources told Reuters that the ECB is ready to buy more Italian bonds if a referendum this weekend roils markets.

Italian government bond yields, indicating the cost at which investors will lend to Rome in the debt markets, have doubled over the past three months ahead of Sunday's referendum on constitutional change that could unseat its prime minister, Matteo Renzi, and deepen a nascent banking crisis.

But shares in lender Monte dei Paschi di Siena, at the centre of Italian banking worries, soared as much as 18 percent on Tuesday, having ended Monday down over 13 percent. The country's benchmark banking index gained 3.8 percent.

The rally in bond and stock markets gained momentum after central bank sources told Reuters the European Central Bank is ready to temporarily step up purchases of Italian government bonds if Sunday's referendum results sharply drive up borrowing costs for the euro zone's largest debtor.

"There is a feeling that if there is volatility then something will be done to assist Italy," said Tomas Kinmonth, a fixed income strategist at ABN AMRO.

Italian 10-year bond yields fell 10 basis points to a more than one-week low of 1.96 percent, down from a 14-month high of 2.16 percent hit earlier in November and on track for its biggest one-day fall in two weeks.

That helped narrow the gap to German equivalents, up 4 bps at 0.23 percent after firm U.S. data, to 174 bps. It briefly touched 193 bps on Monday, its widest since February 2014.

COLOSSAL SHORTS

In another sign of a shift in sentiment towards Italy, a top bond investor for BlackRock Inc, the world's largest asset manager, said on Monday he was scaling up exposure to European banks and still held exposure to Italian government debt.

Others, too, are staking contrarian bets on Italy, as many big international investors hold huge short positions on Italian assets.

"Stocks and government bonds are heavily correlated in Italy. They are basically seen as expressions of the same risk," Intesa Sanpaolo strategist Sergio Capaldi said.

"We are seeing a correction right now. It seems financial markets are getting more relaxed about the idea of a 'No' in the referendum."

As this graphic shows, there is evidence that investors have taken 'short' positions in Italian debt - entering contracts to sell bonds at an agreed price in the future - on a scale not seen since the euro zone debt crisis. http://reut.rs/2fLW0lO

Analysts say a fall in futures prices and a corresponding rise in open interest is tell-tale sign of this trend. In a note on Tuesday, Morgan Stanley's strategists said that trend-following funds known as CTAs, as well as fast and real money investors, had "sizeable" shorts.

The CEO of the Italian exchange said on Tuesday that big international investors are holding "colossal" short positions on Italian assets.

Italy's borrowing costs rose sharply at an auction on Tuesday, reflecting political worries, but firm demand suggested some investor were hedging their "short" positions by buying the underlying bonds.

The country sold 6.2 billion euros of the debt on offer, which was at the top end of a planned range.

Citi said in a note on Tuesday that markets had largely priced in a slim "No" in Sunday's constitutional referendum, seen as a proxy confidence vote on Renzi, but said it "wouldn't buy the dip and remained cautious".

Renzi has promised to step down if he does not win the vote, opening the way for renewed political instability in the euro zone's third-largest economy and prompting fears of bank runs and credit rating downgrades.

Italian newspapers on Tuesday speculated that Renzi may resign even if he wins the vote.

This poses broader risks of a future government potentially taking Italy out of the euro, or taking policy moves that lead to markets forcing it towards a debt default.

An investor survey showed the chance of Italy leaving the euro zone over the next 12 months at 19.3 percent on Tuesday, the highest reading since the poll started in June 2012.

(Graphic by Vikram Subhedar; Editing by Tom Heneghan/Hugh Lawson)