Italian yields fall, supply easily absorbed as political crisis ebbs
* Property tax deal offers respite to Italian debt
* Italian bond sale hits upper end of target
* Bunds edge up on caution over Syrian turmoil
By Emelia Sithole-Matarise and Ana Nicolaci da Costa
LONDON, Aug 29 (Reuters) - Italian bond yields fell on Thursday as the market easily absorbed a debt sale after the government agreed to scrap a property tax, for now smoothing over divisions in the country's fragile ruling coalition.
Low-risk German bonds also rose on uncertainty over the West's response to turmoil in Syria, even as the threat of an imminent military strike appeared to ebb.
The Italian deal replacing the levy on primary properties with a "service tax" offered respite for the country's debt. But strategists said political tensions could flare again in coming weeks when lawmakers decide whether former premier Silvio Berlusconi should be ejected from parliament after his tax fraud conviction.
Auction costs rose for a new five-year bond, but longer-term yields were stable and Italy managed to sell all the 6 billion euros it was targeting.
"It's a reasonably positive set of results, perhaps aided in part by the ruling coalition's agreement yesterday as regards the contentious issue of property taxation," said Richard McGuire, senior fixed income strategist at Rabobank.
"While political risk in Italy will remain elevated over the immediate term as Berlusconi's uncertain tenure within the Senate places a question mark over the government's longevity, today's sales give no indication these concerns are having much in the way of a material impact on investor appetite."
Italian 10-year yields were last 2.5 basis points down on the day at 4.38 percent, while equivalent Spanish yields were 1.6 bps higher at 4.55 percent.
The Spanish/Italian yield spread has widened to 16 bps from its tightest in 1-1/2 years hit on Tuesday at 2 bps. Some strategists are expecting it to rise further in coming days, with month-end-related buying expected to favour Italian debt as domestic investors return after the European summer break.
"The odds are for a spread reversal in the near term, with upcoming month-end index extensions being supportive for BTPs, domestic political risks abating and next week's Spanish government bond auctions moving into the market's focus," Commerzbank strategists said in a note.
"However, with additional policy risks looming large in September we see good reason to sideline our peripheral spread tightening view versus Bunds," they said, citing a potential escalation of the Syrian crisis.
The Bund future settled 30 ticks up at 140.60 in a choppy trading session, with traders expecting it to remain underpinned into the weekend due to geopolitical concerns. It briefly fell on data showing the U.S. economy accelerated more quickly than expected in the second quarter.
"Geo- political risk is maybe back in play and probably will be into the weekend," one trader said.
German 10-year yields were 2 basis points down at 1.85 percent, drawing away from Friday's 1-1/2 year high.
"We are seeing 10-year Bund yields well supported around 1.90 percent level at the moment, despite the bounce-back in equities," Nick Stamenkovic, bond strategist at RIA Capital Markets said.
"The overarching theme is one where there is still geopolitical tensions in the background but markets are increasingly looking forward to next week's U.S. employment report and the ECB Council meeting. So I think we are going to see a period of consolidation near-term."
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