EURO GOVT-Italian bonds stabilise before tricky debt auction
* Election result seen fuelling deeper sell-off in Italy
* Demand may weaken at Italian debt sale
* Bernanke comments tempering safe-haven flows
By Marius Zaharia
LONDON, Feb 27 (Reuters) - Italian bonds steadied on Wednesday ahead of a major debt auction that is threatened by worries political deadlock will cripple efforts to reform its indebted economy.
This week's general election produced a hung parliament and showcased the Italian population's lack of support for budget cutbacks, raising worries that whatever new government is formed may be unable to keep its 2 trillion euro debt burden under control.
The political deadlock could escalate into a new wave of contagion in the euro zone, seven months after European Central Bank President Mario Draghi won some respite with his pledge to do "whatever it takes" to save the euro, analysts say.
The ECB's bond-buying programme (OMT) is still seen as a force acting against debt costs reaching unsustainable levels. But it requires countries to first apply for aid and then stick to an agreed programme of austerity, raising questions about how soon it could be activated.
"Italy has reminded everyone that triggering the OMT ... is not as easy as the market thought," said Gilles Moec, economist at Deutsche Bank. "As it is a reminder of the fragility of the entire system, it has a negative impact for the risk premium for the entire periphery."
"Now, is it enough to send us into the kind of mayhem in which we were last summer? No. It raises the bar for ECB intervention but it doesn't kill the idea."
Italian 10-year bond yields were steady at 4.90 percent, having risen about half a percentage point this week. They are still well below last July's highs of about 6.7 percent.
Spanish, Portuguese and Irish yields, which have been dragged up by Italy this week, were also stable on Wednesday.
The longer it takes for Italy to form a government, the higher the chances of a bigger sell-off, analysts say. Near-term, however, the direction depends on how well an auction of up to 6.5 billion euro worth of 5- and 10-year debt is received.
Yields are expected to rise sharply and demand is expected to be weaker than at previous sales, mirroring the outcome of a T-bill auction on Tuesday.
"Supply will be the main focus and ... it could be a bit of a problem," one trader said, adding that he expected Italian 10-year yields to eventually rise above Spain's, which last traded at 5.35 percent.
On the other hand, the possibility that the sale could go smoothly kept other parts of the market wary that peripheral markets could enjoy some relief.
"Provided the auctions are carried out without any major digestion problems, as we expect, this could offer some brief respite from the current risk averse environment," Credit Agricole strategists said in a note.
Safe haven German Bunds were stable as U.S. Federal Reserve Chairman Ben Bernanke's defence of the central bank's stimulus programme eased some of the past week's concerns over the outlook for global growth.
Bund futures were last 2 ticks higher on the day at 144.92, having rallied 128 ticks in the previous two sessions.