Italian bonds underperform euro zone peers as showdown looms over Berlusconi
* Italian yields rise after centre-right threats
* Spanish/Italian yield spread at tightest since March 2012
* Italy returns to market this week after summer break
* German yields retreat from 1-1/2 year highs
By Marius Zaharia and Ana Nicolaci da Costa
LONDON, Aug 26 (Reuters) - Italian bond yields rose on Monday as a political showdown loomed over former premier Silvio Berlusconi, underperforming their euro zone peers in the week the country comes back to the market after a summer break.
Berlusconi's centre-right party has threatened to bring down the government if its centre-left coalition partners vote next month to expel him from parliament after he was convicted of tax fraud.
Analysts warned against reading too much into market moves, with liquidity thinned by a UK public holiday, and said the price action on Tuesday would better reflect investor sentiment.
Nevertheless, they say political uncertainty has helped narrow the premium that 10-year Spanish government bonds offer over their Italian counterparts to its lowest since March 2012.
"Both countries have political issues, but in Spain they are much more contained. There is higher political risk in Italy," Rabobank market economist Elwin de Groot said.
Ten-year Italian yields rose 5 basis points to 4.39 percent, widening the spread over equivalent German yields by 9 basis points to 249 bps. The yield premium that Spanish 10-year debt offered over equivalent Italian paper shrank to 8 bps, its tightest in 1-1/2 years.
Italy will offer up to 3 billion euros of zero-coupon bonds (CTZ) and up to 1 billion euros of bonds linked to euro zone inflation on Tuesday, but the real test of sentiment will be a sale of longer-term nominal bonds on Thursday.
The different debt issuance outlooks between Italy and Spain have also helped narrow the yield gap, analysts said. While Spain aims to cut monthly issuance by a third, Italy plans to keep up the pace.
Before Spain announced its plans, the yield gap between the two was about 30 basis points.
"It looks as if the market is making slowly some room to be able to digest the supply," one trader said.
POOR U.S. DATA
German yields retreated from the 1-1/2 year highs hit last week as an improved global economic outlook fuelled expectations the Federal Reserve could reduce monetary stimulus in September, while other central banks might struggle to keep their promise to keep interest rates low for a long time.
U.S. durable goods data on Monday cooled some of those expectations as they posted a bigger-than-expected 7.3 percent drop in July.
Ten-year yields were last 4 basis points lower at 1.90 percent, off last week's highs of 1.98 percent. Bund futures closed 47 ticks higher at 140.05, having fallen as far as 139.06 on Friday - their lowest since September 2012.
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 Fed outlook.
"What has been a bit of a burden for the market was simply the uncertainty about tapering. At current levels we could imagine that (Bunds) will find a bit of support, with the help of mixed data rather than positive data," Guntermann said.
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