EURO GOVT-Spanish debt rallies but outlook remains volatile
* Spanish short-term debt revived by domestic buyers * Italy elections, Spain scandal to keep investors on edge * Irish rally extends as banking debt deal wins favour By William James and Emelia Sithole-Matarise LONDON, Feb 8 (Reuters) - Spanish bond yields fell on Friday as buyers re-emerged to take advantage of a recent selloff but the respite was likely to prove temporary with political risks in Spain and Italy set to keep investors on edge. Shorter-dated Spanish bonds felt the greatest force of the buying with traders citing domestic investors as driving a 7.5 basis point fall on two-year bonds that left yields at 2.75 percent. "There may be some correction after the recent rewidening of spreads and it seems to be coming from the domestic front and maybe some follow-up buying after the strong auction yesterday," said Mathias van der Jeugt, a rate strategist at KBC. Ten-year yields dipped 5 bps to 5.37 percent, roughly in the middle of this week's wide 30 bp trading range after a volatile week caused by allegations of corruption that have put pressure on Prime Minister Mariano Rajoy. Though Rajoy has denied any wrongdoing in the scandal, Spanish bonds investors were likely to remain sensitive and keep bond trading choppy. "If you get a government that's having to do whatever it can to regain popularity then focus on reforms and deficit cutting goes out the window, so that will remain a concern," said Elisabeth Afseth, strategist at Investec in London. Spanish debt outperformed its Italian counterpart heading into a week where bond sales from Rome will be a key focus as the country's general election draws closer. The rising popularity of former premier Silvio Berlusconi has put some investors on alert, wary that reform commitments might slip. Italy will sell short-term bills, longer-term bonds and floating rate notes next week, and while demand was not expected to fall short at the auctions, the strength of bidding will be closely watched as a gauge of investor confidence. "They'll probably get it away, we're not at the stage where that's a problem, but I can't see anyone going in and bidding aggressively ahead of the election," Afseth said. GREEN IS GOOD Irish bonds enjoyed another strong day as investors continued to warm to a deal reached on Thursday that eased the burden of financing the country's banking bailout and boosted Dublin's prospect of exiting its bailout on schedule. The yield on the Irish 2020 bond sank 15 basis points to 3.85 percent, extending the decline since the banking deal to 25 basis points. Irish yields are now below Italian equivalents in shorter maturities and at their lowest levels since before the start of the financial crisis in 2007. "Obviously Ireland is trading through Italy and (the move) can have further legs. Such a trade will even benefit from Ireland being flat and Italy getting some issues with the elections," Commerzbank strategist David Schnautz said. German debt ended the week with a low volume session in which prices traded in a half-point range but closed barely changed at 142.81. Early gains were wiped out late in the afternoon, tracking a slide in U.S. debt prices which were affected by a heavy week of new debt supply.