EURO GOVT-Italy underperforms, focus on year-end auctions

* Italy underperforms ahead of year-end auctions

* Bunds steady, seen retesting contract highs

By William James

LONDON, Dec 23 (Reuters) - Italian bonds were the main underperformer in euro zone government debt markets on Friday, with yields rising relative to Germany as investors looked ahead nervously to Italy's final bond auctions of the year next week.

Market activity was very thin in the last trading session before Christmas, exaggerating any price moves, but Italian bond yields rose across the curve, with the 10-year yield breaking above the 7 percent level.

That level has been seen as the key benchmark, above which doubts escalate about whether Italy can afford to fund its maturing debt.

Supply worries will dominate trading ahead of large Italian redemptions early next year, with the next test coming as soon as next week at sales of three and 10-year debt.

"It's going to be a pretty tough month for BTPs. It really does depend which side of the bed the market gets out of on the first trading day of next year," said David Keeble, global head of fixed income strategy at Credit Agricole.

"It's sentiment driven so it could go very well, it could go very badly, I just don't think there's much inbetween."

Doubts also grew over whether huge demand for the European Central Bank tender of cheap banking loans earlier this week will be effective in easing the strain for troubled euro zone economies.

The ECB stepped back into secondary markets this week to cap a rise in yields and departing Executive Board member Lorenzo Bini Smaghi said the central bank has the option to use quantitative easing-style policies and can also boost its bond buying if required.

Yields on Italian 10-year bonds were 8 basis points higher at 7.01 percent, with the Spanish equivalent almost 2 basis points lower at 5.41 percent.

BUNDS STEADY

German debt was set to remain supported with the threat of mass sovereign credit ratings downgrades by Standard and Poor's for the euro zone still hanging over markets. The rating agency's verdict is expected in January, two European government sources told Reuters.

March Bund futures were 20 ticks lower on the day at 137.63 with 10-year yields one basis point higher at 1.953 percent.

Technical charts pointed toward continued strength for Bunds while the contract traded above 136.72, the 38 percent retracement of the late November to mid-December rally, UBS technical analyst Richard Adcock said.

"The immediate risk is back to the 138.86 failure high, with breaks of this triggering upside to 139.23 and then the November monthly extreme at 139.74," he said.

German bonds overall have seen total returns of 8.95 percent year-to-date, according to the Markit iBoxx index while Italian bonds have been one of the worst performers, posting losses of 5.65 percent overall.

Above-average month-end index extensions - when investors benchmarked to indexes adjust the duration of their portfolios to reflect changes due to recently maturing and issued bonds -- were also seen supporting German debt.

The largest index extension were seen for Belgian debt, with the 10-year rallying 11 basis points on the day.