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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 down sharply

* Markets shrug off U.S. government shutdown

By Marius Zaharia and Ana Nicolaci da Costa

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

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

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

The ministers stepped down amid conflict over an imminent sales tax hike, but allies of Berlusconi have also threatened to withdraw support for the cabinet if the former premier was evicted from parliament following his tax fraud conviction.

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

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

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

Spanish yields were down by 13 basis points to 4.18 percent, not showing any signs so far of the usual selling pressure countries feel before debt auctions. Spain is due to sell up to 3.5 billion euros of bonds on Thursday.

"The events in Italy have added momentum to (Spain's strong performance) because people now reassess the peripherals and judge countries individually," Commerzbank rate strategist Michael 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-term refinancing operation, after European Central Bank President Mario Draghi flagged that possibility last week, as supporting high-yielding debt. The ECB meets on Wednesday and is expected to stick with its accommodative monetary policy.

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


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

Lawmakers could not break a political stalemate, raising fresh concerns about whether Congress can meet a crucial mid-October deadline to raise the government's $16.7 trillion debt ceiling and avoid default.

German Bund futures closed 24 ticks lower at 140.26 but some analysts said the backdrop was broadly supportive for safe-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 the government shutdown but obviously they are not pricing in, at least at this point, the consequences of a failure to raise the debt ceiling," Rabobank market economist Elwin de Groot added.