* Bernanke's testimony reassures on bond purchases * Italian political stalemate adds safety bids * U.S. Treasury sells $35 bln 5-year debt to average demand * Stock gains, encouraging data pressure on bond prices By Karen Brettell NEW YORK, Feb 26 (Reuters) - U.S. Treasuries prices fell on Tuesday, though yields held near their lowest levels in a month, as political instability in Italy boosted demand for lower risk assets and after Federal Reserve Chairman Ben Bernanke defended the U.S. central bank's bond purchases. Italy's political parties looked for a way forward after an election gave none of them a parliamentary majority, posing the threat of prolonged instability and a rekindling of the European financial crisis. Italian bond yields surged. In keenly awaited testimony to Congress on Tuesday, Bernanke strongly defended the Fed's bond-buying stimulus, easing some speculation that monetary policymakers might be getting cold feet. He acknowledged the risks from the U.S. central bank's bond purchases, which have ballooned its balance sheet to more than $3 trillion, but said the Fed has the ability to manage these risks. "Bernanke's commentary showed the Fed chairman wants to continue quantitative easing and keep its general stance of monetary policy accommodation," said Eric Stein, vice president and portfolio manager at Boston-based Eaton Vance Investment Managers. The release last week of Fed meeting minutes showing that some policymakers are increasingly cautious about continuing the U.S. central bank's bond purchase program heightened speculation that the buybacks could be ended before year-end, sooner than most investors have expected. The Fed is buying $85 billion in bonds each month and has said it will keep purchasing assets until it sees a substantial improvement in the labor market. It bought $1.45 billion in Treasuries due 2036 and 2042 on Tuesday as part of this program, and will buy between $4.25 billion and $5.25 billion in debt due 2017 on Wednesday. Benchmark 10-year Treasuries were last down 6/32 in price in choppy trading to yield 1.886 percent, up 2.1 basis points. The 10-year yield fell as low as 1.836 percent in overnight trading. The modest decline in bond prices was partly attributable to a rebound in Wall Street stocks a day after posting their biggest one-day loss since November. The Standard & Poor's 500 index was up 0.5 percent, less than a third of Monday's drop. Fears over new instability in the euro zone helped send Treasuries yields tumbling on Monday, breaking below technical resistance at 1.85 percent. "The possibility that European voters may reject austerity measures encourages investors to seek safety in Treasuries," said Kathy Jones, fixed-income strategist at Charles Schwab in New York. The safe-haven bid for U.S. bonds helped the Treasury sell $35 billion in five-year notes on Tuesday, the second sale of $99 billion in new supply this week. The notes sold at a high yield of 0.78 percent, in line with where they were trading before the sale. The U.S. government will auction $29 billion in seven-year notes on Wednesday. Investors are also focused on $85 billion in automatic, across-the board spending cuts due to come into force on Friday unless lawmakers reach a budget deal to avoid them. President Barack Obama and others have warned the measures will harm the country's still fledgling economic recovery. "Fiscal policy has already been tightened with the end of the payroll tax cut, and now the prospect of sequestration starting at the end of this week could mean even more constraint on consumer incomes and spending," Jones said. The U.S. economy has been grinding along, helped by improvement in the housing market. U.S. home prices recorded their biggest annual gain in more than six years, according to the Standard & Poor's/Case-Shiller index released on Tuesday. Government data showed the pickup in housing activity continued in 2013 with new home sales jumping 15.6 percent in January to a 4-1/2-year high.