Italian bonds rally as government seen surviving confidence vote


* Centre-right MPs say they will back Italian government

* Italian, other low-rated euro zone debt yields downsharply

* Markets shrug off U.S. government shutdown

By Marius Zaharia and Ana Nicolaci da Costa

LONDON, Oct 1 (Reuters) - Italian bonds rallied on Tuesdayon signs the government will have sufficient support in aconfidence vote to avoid a fresh round of tightly-contestedelections.

Other low-rated euro zone bonds also firmed, shrugging offthe U.S. government's first partial shutdown in 17 years, withmarkets expecting the deadlock over borrowing limits in theworld's largest economy to be only temporary.

A prominent centre-right Italian senator said the majorityof MPs in Silvio Berlusconi's party did not want to bring thegovernment down, easing some of the tensions triggered by theresignation of five ministers at the weekend.

The ministers stepped down amid conflict over an imminentsales tax hike, but allies of Berlusconi have also threatened towithdraw support for the cabinet if the former premier wasevicted from parliament following his tax fraud conviction.

Italian 10-year bond yields fell 14 basispoints on the day to 4.44 percent, narrowing the gap overbenchmark German Bunds to 272 basis points, after trading atover 300 bps early on Monday.

"There's a bit more optimism in Italy," said Alan McQuaid,chief economist at Merrion Stockbrokers in Dublin. "If Italygets by tomorrow with a government still in place I wouldn't besurprised if Italian debt outperformed near-term."

Other analysts expected the recent events in Italy to have amore lasting impact on investor confidence. Worries about theimpact shaky politics might have on the Rome's ability toimplement reforms and contribute to the nascent euro zoneeconomic recovery are likely to linger, they said.

Spanish yields were down by 13 basis points to4.18 percent, not showing any signs so far of the usual sellingpressure countries feel before debt auctions. Spain is due tosell up to 3.5 billion euros of bonds on Thursday.

"The events in Italy have added momentum to (Spain's strongperformance) because people now reassess the peripherals andjudge countries individually," Commerzbank rate strategistMichael Leister said

Less liquid Portuguese and Greek bonds saw their 10-year yields falling by around 20 bps.

Traders and analysts also cited talk of another long-termrefinancing operation, after European Central Bank PresidentMario Draghi flagged that possibility last week, as supportinghigh-yielding debt. The ECB meets on Wednesday and is expectedto stick with its accommodative monetary policy.

Ireland's debt agency said on Tuesday it has decided not toissue any more bonds this year, forgoing the chance todemonstrate its access to markets. The comments had littleimpact on its bonds.


Analysts said debt markets showed a muted reaction to theU.S. government shutdown because it was expected to be temporaryand because markets had already priced it in to some extent.

Lawmakers could not break a political stalemate, raisingfresh concerns about whether Congress can meet a crucialmid-October deadline to raise the government's $16.7 trilliondebt ceiling and avoid default.

German Bund futures closed 24 ticks lower at 140.26but some analysts said the backdrop was broadly supportive forsafe-haven assets and they could still rise going forward.

"That (muted market response) is a sign that the market has... already priced in the negative economic impact of thegovernment shutdown but obviously they are not pricing in, atleast at this point, the consequences of a failure to raise thedebt ceiling," Rabobank market economist Elwin de Groot added.

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