RPT-Italian yields brave political tension, eyes on Thursday auction
* Italian yields edge higher after centre-right threats
* Italy returns to market this week after summer break
* German yields hover near highest in 1-1/2 years
By Ana Nicolaci da Costa
LONDON, Aug 26 (Reuters) - Italian yields largely braved rising political tension in the euro zone's third largest economy on Monday only days before Italy returns to the market after a summer break.
Italy's borrowing costs rose after a threat to the coalition government's survival but analysts warned against reading too much into price moves, given thin liquidity due to a UK holiday.
Members of Silvio Berlusconi's centre-right party warned on Sunday they would bring down the government if their centre-left coalition partners voted next month to expel the former premier from parliament over a tax fraud conviction.
Analysts said this could cast a shadow over a bond sale on Thursday. However, they expected politicians to find a last-minute deal to avoid a crisis, while Italy's comfortable funding position was expected to allow it to withstand any rise in yield.
"The market is underestimating the risk, because the risk of having a government crisis is far from low," Alessandro Giansanti, senior rates strategist, at ING said.
"We have to weigh these negative factors with the positive factors, which is coming from an improved economic outlook."
Ten-year Italian yields were 3.4 basis points higher at 4.37 percent, and two-year borrowing costs were up 2.8 bps at 1.82 percent.
German 10-year yields fell 1.2 bps to 1.92 percent, still near their highest in 1-1/2 years. It hit 1.98 percent on Friday - its highest since March 2012.
U.S. durable goods data later on Monday will come in focus as markets seek clarity on whether the Federal Reserve will begin slowing bond purchases as soon as next month.
Other data highlights this week include Ifo German business morale and a second reading of U.S. growth numbers.
Commerzbank strategist Rainer Guntermann expected 10-year German yields to stay at 1.90-2.00 percent until next week's U.S. jobs data, which would be "decisive" for the tapering debate.
"What has been a bit of a burden for the market was simply the uncertainty about tapering. At current levels we could imagine that yields will find a bit of support, with the help of mixed data rather than positive data," Guntermann said.
German Bund futures were 24 ticks higher at 139.82, having fallen as far as 139.06 on Friday - its lowest since September 2012. Further downside was expected however.
"As the indicator situation is negative in both the weekly and daily charts, further losses towards the September 2012 low of 138.41 are possible this week," Helaba Landesbank Hessen-Thueringen said in a note.
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