By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Oct 2 (Reuters) - Italian government bond yields fell on Wednesday after Prime Minister Enrico Letta won a confidence vote from lawmakers following former premier Silvio Berlusconi's climbdown from threats to topple the coalition.
Italian debt outperformed other euro zone bonds, which were steady to slightly weaker after the European Central Bank left key interest rates unchanged and gave no hint fresh monetary easing was imminent.
The confidence vote in Italy was called after five ministers from Berlusconi's party resigned at the weekend. The media tycoon and former prime minister's allies have threatened to bring the government down if he is evicted from parliament following a tax fraud conviction.
Berlusconi backed off just before the confidence vote in parliament after divisions within his camp widened sharply this week, easing market concern that Italy could face a fresh round of potentially inconclusive elections.
"We can continue to see the relief rally going on in Italian BTPs after Berlusconi's PDL guys backed Letta, weakening Berlusconi quite considerably," said David Schnautz, a senior strategist at Commerzbank in New York.
"On a short term basis the domestic newsflow out of Italy is as close to as good as it can get. The situation was close to the brink but it's not like now we have a firm or stable government. Overall, there's structural instability which is still prevailing."
Italian 10-year yields fell more than 10 basis points to 4.34 percent, reversing a recent rise which took them over 4.70 percent. They were back to levels seen a week ago just before the media tycoon and former prime minsiter's allies threatened to bring the government down if he was evicted from parliament following a tax fraud conviction.
The cost to insure Italian debt against default via five-year credit default swaps fell 6 basis point to 248 basis points, according to data monitor Markit.
Some analysts say renewed parliament backing might strengthen Letta's authority to push through reforms.
"Maybe Berlusconi pushed it too far this time and ... after all this we could have a more stable government than the one we had before. Italy may come out stronger," Nordea chief analyst Anders Svendsen said.
Italian bonds also clawed back some ground against Spanish equivalents, though 10-year yields were still 11 bps above Spanish ones.
"Short-term there's potential we may see more switching out of Spain into Italy but overall we see the 10-year Italian yield falling to 4.25 percent," Schnautz said.
ECB STANDS PAT
The first U.S. government shutdown in 17 years was having little impact on the region's debt markets as many investors view it as only temporary.
German Bund futures rose 6 ticks to settle at 140.32 after ECB President Mario Draghi signalled no imminent policy easing. He reiterated the bank was watching moves in market interest rates closely and was ready to use any policy option to temper them if needed.
"We continue to envisage another very long-term refinancing operation before year end, likely with different characteristics, for example fixed to the current benchmark interest tate, if the liquidity surplus continues to shrink in the coming months," Barclays Capital strategists said in a note.
While Bunds, regarded as a safe-haven asset, showed no obvious reaction to the U.S. government shutdown, the cost of insuring U.S. government bonds for one year rose above that of insuring the debt for five years for the first time since July 2011.
The curve inversion is considered a classic sign of stress as normally a longer-term insurance would be costlier.