By Lisa Jucca
MILAN, Sept 30 (Reuters) - Expectations that a rebellion within Silvio Berlusconi's party may avoid snap elections in Italy pulled bond yields off the day's highs and curbed stock market losses.
Investors had sold Italian government bonds and shares earlier on Monday after Berlusconi pulled the rug from under Prime Minister Enrico Letta's frail coalition government by ordering five centre-right ministers to quit.
But the market turned after Reuters reported that as many as 20 senators from Berlusconi's centre-right party were ready to break away unless the media tycoon backed down from his hard line. This may help Letta build a new workable majority.
"The market turned as the rebellion within Berlusconi's party is dimming the prospect of snap election," a trader at a primary Italian bond dealers said.
Berlusconi, 77, is facing eviction from parliament after a tax fraud conviction.
His weekend decision to try and topple Italy's coalition government had initially spooked investors who feared political strife within the euro zone third largest economy may ripple beyond the country's borders.
Rome has failed to reform its electoral law and investors said snap elections would lead to political paralysis.
After an initial spike, yields on Italy's 10-year bond, a good indicator of long-term sentiment towards Italy, were trading at 4.59 percent at 1445 GMT, the same level they stood at on Friday before the political crisis flared.
The yields were well below a 7.5 percent peak hit when Italy reached the height of its sovereign debt crisis in 2011.
Shares in Milan's blue-chip FTSE MIB, which had plunged 2.5 percent minutes after opening, cut their losses and were down 1.2 percent, with banking stocks and broadcasting group Mediaset, controlled by Berlusconi, among the worst-performer.
The index remains on track to end the quarter with a 14 percent gain, its best performance since 2009.
The latest political spat comes as next year's budget law is currently under negotiations. Italy is also in the middle of corporate turmoil that has prompted management shake-ups at its biggest retail bank, Intesa Sanpaolo and telecoms company, Telecom Italia. No.3 bank Monte dei Paschi di Siena is still waiting for a EU green light to badly-needed state aid.
Economists at Lavoce.info, a popular Italian independent think-thank, said the country risked a further downgrade of its credit rating that could spark a fresh sell off of Italian debt.
"Italy needs to rapidly give a sign of stability to avoid this scenario," the think-thank said in a statement.
But there are positives.
Economic conditions have much improved since the country's borrowing costs came close to unsustainable levels in late 2011. Fiscal austerity measures pushed through by former premier Mario Monti are expected to curb fiscal slippage and the Treasury has already met 80 percent of its debt funding needs this year.
In addition, many investors take comfort from the European Central Bank's bond-buying backstop.
Letta will go before parliament on Wednesday and hold a confidence vote - a move that will clarify what is left of his parliamentary backing.
The centre-left politician enjoys a commanding majority in the lower house but would need to win over a couple of dozen senators from Berlusconi's PDL party or opposition parties including the anti-establishment 5-Star Movement to secure parliamentary support.
This could be within reach if the 20 or so PDL runaway lawmakers agree to back him.
"In our view, new elections are still unlikely this year, with the coalition government likely to gain the confidence vote this week," said Alberto Gallo, credit analyst at Royal Bank of Scotland.
"However, the government's ability to pass structural reforms and handle the crisis around Italy's corporates and banks remains in question."