EURO GOVT-Italian bonds dip but ECB backstop tempers selloff
* Italian yields rise, Bund futures hit 2013 high
* Italian politics to remain key market driver near-term
* ECB backstop tempers selling pressure
By Marius Zaharia and Emelia Sithole-Matarise
LONDON, March 4 (Reuters) - The lack of progress in talks to form a government in Italy weighed on the country's bonds on Monday, but the ECB's so far untested bond-buying backstop prevented a deeper sell-off.
Elections last week produced a hung parliament, raising the risk of prolonged political deadlock, a re-run of the polls and the paralysis of efforts to keep Italy's 2 trillion euro ($2.6 trillion) public debt under control.
Pier Luigi Bersani, who won a lower house majority for the centre-left but could not win the Senate, has issued an ultimatum to anti-establishment leader Beppe Grillo to support a new government or return to the polls.
Italian 10-year bond yields were last 8 basis points higher on the day at 4.87 percent, underperforming all euro zone bonds apart from Greece's.
Italian debt has fared worst against Spanish bonds over the past week. Their 10-year yield gap is now at its tightest since early May around 23 basis points, with many strategists expecting yields to equalise in coming weeks.
"BTPs are still yielding less than Spain but the gap is closing. The (underperformance) of BTPs versus Spain could continue for a few weeks because we know that ... even in the best of scenarios, it will take a few weeks for a government to be formed," said Ciaran O'Hagan, a strategist at Societe Generale.
"If the (politicians) get their act together and agree on a programme of government that's coherent and looks appealing, then the spreads can be contained - otherwise we will end up with BTP yields once again above Spanish yields," he said.
Although the potential consequences of the impasse prompted some analysts to warn of a wider selloff in the euro zone, most of the selling in Italian bonds was being met by buying from some yield-hungry investors.
The European Central Bank's conditional promise last year to buy bonds issued by struggling states offered investors an incentive to hold risky assets, although some in the market have questioned how the scheme could be activated if Italy did not have a government prepared to commit to the ECB's conditions.
"We're left with the prospect of weeks and weeks of political wrangling ... and I can't help feeling there's going to be more upward pressure on Italian yields," ICAP strategist Philip Tyson said. He said his pre-election target was 5 percent, but he now saw yields heading towards 5.5 or even 6 percent in coming weeks.
"It looks contained at the moment. There's a feeling you've got more backstops in place. Personally, I question that ... Yes, (the bond-buying programme) is there, but it's less of a backstop than it was."
Bersani has ruled out a "grand coalition" with Silvio Berlusconi's centre right, while former comedian Grillo has said he will not give a vote of confidence to any government and could only consider backing individual laws. Grillo also said over the weekend that he supported a non-binding vote on Italy's euro zone membership.
Any agreement between the parties is seen as short-lived, while a technocrat government pursuing austerity is seen as an unpopular option that may increase support for Grillo.
"It's still going to be a mess," a trader said. "Nothing is being sorted out in Italy in the short run so we should be in for a volatile market."
Traders said Italian bonds were bought mostly by domestic investors and hedge funds taking profits on their post-election selling positions. Longer-term foreign investors preferred low-risk German debt.
Bund futures were settled unchanged on the day at 145.51, having hit a 2013 high of 145.80 earlier in the session. One trader noted increased bidding at around the Feb. 27 high of 145.40 and said the high of 145.82 hit in the last session of last year acted as near-term resistance.
Despite a rally of nearly two points in the Bund future over the past week and a fall of about 15 basis points in the cash 10-year yield, which last traded at 1.42 percent, DZ Bank strategist Christian Lenk recommended investors to favour German debt.
"We stay on the safe side, we favour core versus periphery because you don't know where this is heading to," Lenk said.
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