EURO GOVT-Italy, Spain bonds rally as Cyprus avoids meltdown
* Clamour for safety recedes; Bunds dip, periphery rallies
* Lack of Cyprus meltdown spurs trimming of safety hedges
* Long-term worries persist, Italy yields seen rising
By William James and Emelia Sithole-Matarise
LONDON, April 2 (Reuters) - Italian and Spanish bond prices rose on Tuesday with investors edging away from low-risk assets as fears of a major financial meltdown emanating from Cyprus receded.
As part of an international bailout agreed just over a week ago Cyprus is set to impose losses of around 60 percent on savers holding more than 100,000 euros.
The deal was the first in euro zone history to make savers share the burden, but Cyprus' banks reopened in orderly fashion on Thursday, allaying fears that long queues to withdraw cash could have sparked a wider bank run across the euro zone.
"There was some fear there could be a bank run but this was not justified so that's one small reason for this fading of risk aversion today. There's maybe some relief that the horror scenario did not become real," said Ralf Umlaf, head of flow research at Helaba Landesbank Hesse-Thueringen.
Italian 10-year yields, were down 9 basis points on the day at 4.65 percent while equivalent Spanish yields were down by the same amount at 4.97 percent.
Nevertheless, analysts expected them to face selling pressure in the coming days, resuming a steady climb in yields over the last two weeks with long-term investors still wary that the Cypriot rescue had set a template for future bailouts while political uncertainty drags on in Italy.
Italian yields have risen 18 bps since March 22, due to its politicians' struggle to form a government after elections in February failed to produce a clear winner.
Italy's president acknowledged on Saturday that he had limited scope to force divided political parties to find a solution, but ruled out standing down early to make way for new parliamentary elections.
Alessandro Giansanti, strategist at ING in Amsterdam, said the impasse could still last some time.
"The market is under-reacting a bit to the negative political news... it's not something that will be solved in one or two weeks," he said.
Giansanti recommended using the current calm to take outright short positions in Italian bonds, also highlighting the risk that rating agencies could downgrade Italy if the deadlock dragged on.
Fitch has already downgraded Italy since the elections and Moody's, which rates the country even lower, at just two notches above junk, has signalled it is monitoring Italian events.
Spanish yields were also seen resuming their recent climb in the run up to bond sales due on Thursday. Madrid will seek to raise up to 4 billion euros in an auction of three-, five- and eight-year bonds that will draw added attention after sluggish demand at a similar sale by Italy last week.
The pickup in demand for riskier assets on Tuesday saw German Bund futures shed 25 ticks to settle at 145.24 as traders closed out positions used to hedge against any contagion from Cyprus to the region's other struggling states such as Spain and Italy.
Analysts said the relief was driven by a trimming of safe-haven bets rather than the start of a full-blown revival in appetite for risk-taking given the lingering worries about Cyprus' messy bailout.
That was set to keep investor demand intact at a German sale on Wednesday of 4 billion euros of five-year bonds.
German 10-year yields were last 2.5 basis points up on the day at 1.31 percent. Bayerische Landesbank strategists expect the yields to stay in a 1.25-1.70 percent range in the next six months until a new Italian government is in place.
"The parliamentary election in Italy and the crisis in Cyprus - both of which have been accompanied by unease on the markets - confirm that uncertainty may palpably weigh on sentiment for the time being," they said in a note.
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