EURO GOVT-Political risks hurt Spanish and Italian bonds
* Spanish and Italian yields rise as political risks grow
* 2013 rally in peripheral bonds reaching stretched levels
* Bunds rebound but remain lower after late Friday selloff
By William James
LONDON, Feb 4 (Reuters) - Spanish and Italian government bond yields rose on Monday as investors grew wary that mounting political uncertainty in both countries could derail this year's strong rally in higher-yielding euro zone debt.
In Spain, Prime Minister Mariano Rajoy was facing calls to resign over a corruption scandal, and in Italy the growing popularity of former premier Silvio Berlusconi was a worry for investors in the run-up to elections this month.
"It's that worry of political instability in both Spain and Italy," a trader said. "Rajoy is under a bit of pressure and Berlusconi seems to be making a good old comeback in the polls as well."
"A lot of people have been bullish Spain and Italy for a few months and it's come a long way but there's a lot of supply to get through and a lot of the early-year money has gone to work."
Peripheral debt has enjoyed a strong start to the year, aided by the easy supply of cash from central banks and the promise that the European Central Bank will step in and buy bonds of struggling states if necessary.
Spanish 10-year government bond yields rose 10 basis points to 5.32 percent while Italian yields were 9 bps higher at 4.42 percent.
Commerzbank strategists said the time was right to start cutting back investments in peripheral debt as current low yield levels tested technical supports and the Spanish political risks mounted.
"Uncertainty from the accusations (against Rajoy) has the potential to weigh on sentiment, giving investors second thoughts about overweight positions in the periphery in general and Spain in particular at current spread levels," they said in a note to clients.
Rajoy denies any wrongdoing.
German Bund futures, often used as a hedge against a flare-up in the region's weaker sovereigns, trimmed early losses when Spanish and Italian bonds started trading but, at 141.78, remained 23 ticks lower than at Friday's settlement.
Much of that fall can be attributed to a steep selloff in U.S. Treasuries late on Friday after labour market and manufacturing data showed recovery in the world's largest economy remained on track.
"Sentiment still remains pretty negative for Bunds. We're testing support around 1.7 percent. To get through that level we're going to need to see further signs of improving sentiment towards the euroland economy," said Nick Stamenkovic, strategist at RIA Capital Markets.
Any rally in Bunds was likely to be used by others as a chance to sell but the potential for another major selloff remained limited due to the sheer scale of recent falls, Stamenkovic said.
The 10-year German yield was last at 1.69 percent, 2 bps higher on the day and 32 bps up compared to levels seen on the final trading session of 2012.
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