EURO GOVT-Italy rallies as ECB backstop trumps political crisis
* Italian bond yields fall for second day running
* ECB meeting seen as key to appetite for German debt
* German auction demand to hinge on ECB policy outlook
By William James
LONDON, March 6 (Reuters) - Italian government bond yields fell on Wednesday as investors put their faith in the European Central Bank's ability to prevent indecisive elections driving Italy into full-blown crisis.
Investors bought back Rome's bonds for a second consecutive session despite expectations that attempts to form a coalition will fail, and with the country's president considering appointing a technocrat government.
Ten-year Italian bond yields were down 8 basis points at 4.66 percent as analysts pointed to the ECB's long-standing, but untested, promise to backstop struggling sovereigns by buying government bonds.
The moves have been supported by a broadly more optimistic mood around the global economy thanks to signals from the United States, as well as expectations of another strong message from the ECB on Thursday on its determination to see out the crisis.
"At the moment the market is looking through everything and saying 'Italy is not going to be allowed to leave the euro zone and it's got too much debt to be allowed to default, so actually this is quite a nice yielding asset," said Lyn Graham-Taylor, strategist at Rabobank in London.
The demand for higher-yielding assets tipped Bund futures , the euro zone's safe haven of choice, 16 ticks lower on the day to 144.87.
The near-term outlook for core debt was dominated by Thursday's ECB meeting, at which dealers expect the central bank to hint at an accommodative policy outlook.
"We think they'll show they had a serious discussion on rates and with the new round of staff forecasts they may just pave the way for a cut," a trader said.
But, while that may encourage bonds broadly to rally in anticipation of lower rates, in the short-term it may help keep investors in the mood to buy the euro zone's riskier debt in favour to Bunds.
"At the moment risk assets seem to take central bank dovishness on board more than bonds do," the trader said.
A German sale of five-year bonds later in the session was expected to see lower borrowing costs than a month ago, reflecting investors' increased desire to hold low risk and highly liquid assets to protect themselves from market turbulence.
However, with five year bonds looking expensive relative to other maturities the strength of demand at the sale will also hinge on how likely the market believes an ECB rate cut is.
"It's a bet on tomorrow's rate decision. If you believe that tomorrow the ECB will cut rates then the five-year (bond) is not that expensive. If don't believe that, it doesn't make sense to go for it," said Patrick Jacq, strategist at BNP Paribas.
Nevertheless, any weakness in core debt was likely to be constrained by the unanswered questions over when and how Italy will resolve its indecisive election.
"The cloud of the Italian political situation is unlikely lift any time soon, which suggests any respite in the flight-to-quality move could be short lived if the lack of news extends for a few more days," said Credit Agricole strategist Orlando Green in a note to clients.
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