REFILE-EURO GOVT-Italian bonds rebound but political crisis looms
* Italian bonds recover early loss as Monti worries ebb
* Italy to remain volatile, supply pressure adds upward bias
* Safety bid for Bunds dented by above forecast German poll
By William James
LONDON, Dec 11 (Reuters) - Italian bonds rebounded on Tuesday from a selloff but a political crisis, sparked by Prime Minister Mario Monti saying he would resign early, was expected to keep Italy's debt volatile in the coming weeks.
A selloff that started on Monday gradually reversed course during Tuesday morning to leave Italian yields down on the day but still well above the two-year lows reached last week.
Market participants said Monday's 27 basis point rise in 10-year yields had been, in part, a knee-jerk reaction, adding that Monti's announcement had only brought forward the well-flagged risks surrounding an Italian election early next year.
Italian 10-year bond yields were 5.6 basis points down on the day at 4.76 percent, having earlier touched a three-week high of 4.9 percent. The yield hit a two-year low of 4.4 percent last week but a return to those levels was seen unlikely in the near term.
"The moves in Italy today are just volatility. I think there are still plenty of reasons to be concerned," said Elisabeth Afseth, analyst at Investec in London.
"While there's definitely pick-up over Bund yields (on Italian bonds), it might be difficult to justify adding to positions and buying at these levels when you have a very uncertain political future there."
Monti, a technocrat who reassured investors Italy was committed to reform, will resign once the 2013 budget has been passed, bringing forward an election and focusing attention on the potential for drawn-out political tussle that could undermine Italy's commitment to austerity.
The return to frontline politics of former Prime Minister Silvio Berlusconi, anathema to many investors, also posed a longer-term risk to stability, analysts said.
Italy will sell new three-year debt alongside an existing 2026 bond at an auction on Thursday, planning to raise up to 4.25 billion euros.
Greek bonds rallied for a fourth day running as the country's debt-reducing buyback drew to a close with local banks expected to have raised their offers to make up for an initial shortfall in participation.
Ten-year Greek yields fell 40 bps to 13.66 percent in anticipation of a successful buyback unlocking aid funding.
At the opposite end of the credit spectrum, ultra-safe German Bund futures fell 27 ticks to 145.33 on the combination of better-than expected economic data from the ZEW think tank and a rise in appetite for higher-yielding debt.
Many traders specialising in "core" government bonds were sidelined awaiting the outcome of the U.S. Federal Reserve's two-day policy meeting starting later in the day.
A Reuters poll showed the Fed is expected to announce that it will extend its asset purchase scheme and commit to buy $45 billion of U.S. debt per month, helping to keep yields low on closely-correlated German Bunds.
"The market will be severely disappointed if we don't get fresh purchases now. You'd feel that outcome is in the price. There's now more risk that they don't do anything and we get disappointment," a trader said.
"Bunds will be sensitive to that, particularly given the rally we've had back to the low end of the yield range.
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