Political woes drive Italian yields above Spain's for first time in 18 months
* Spanish yields below Italy's for 1st time since March '12
* Concerns over immediate military attack vs Syria recede
* Safe-haven bonds fall sharply, periphery benefits
LONDON, Sept 10 (Reuters) - Spanish yields fell below Italy's for the first time since March 2012 on Tuesday as Italian bonds underperformed on concerns over the survival of a fragile government coalition.
Both Italian and Spanish yields fell as concerns over an imminent military attack on Syria receded, prompting German Bund prices to hit their lowest since March 2012.
But Italian bonds lagged Spain's as allies of Silvio Berlusconi stepped up warnings that they would bring down Italy's unstable ruling coalition if centre-left lawmakers refuse to delay a hearing over expelling the billionaire former prime minister from parliament.
A cross-party Senate committee, which is deciding whether Berlusconi should be stripped of his seat in the upper house following a conviction for tax fraud last month, was due to resume talks later on Tuesday after an initial meeting on Monday.
"I am not a great fan of Spain but, in the short term, I think there is much more downside potential for Italy because of the political situation at the moment which is getting worse," Gianluca Ziglio, executive director of fixed income research at Sunrise Brokers, said.
Ten-year Italian yields were down 3.2 basis points at 4.50 percent and Spanish yields were 6 bps lower at 4.49 percent.
The premium 10-year Spanish yields offer over Italy fell below zero, with Italian yields overtaking their Spanish counterparts by as much as two basis points earlier. They had stood 2 basis points below Spanish yields in the previous session.
A collapse of the government could stall any recovery in the Italian economy at a time when euro zone data is pointing to a brighter outlook for the region.
Bank of Italy governor, and European Central Bank governing board member, Ignazio Visco said as much on Tuesday, warning political instability could unsettle financial markets and put at risk an expected end-year economic recovery.
Michael Leister, senior interest rate strategist at Commerzbank, said Italian yields could rise even further above Spain's over the next four to six weeks.
"Spain seems to be faring better (given its) growth prospects and also the way (in which) reforms have been implemented on all these structural issues ... favour Spain at the moment," Leister said.
"The big question mark behind the current Italian government, this Berlusconi issue, is also weighing on sentiment."
WINDOW OF OPPORTUNITY
Investors dumped safe-haven bonds as Interfax news agency quoted Syria's foreign minister as saying the government had accepted a Russian proposal to put its chemical weapons under international control to avoid a possible U.S. military strike.
U.S. President Barack Obama said on Monday he saw a possible breakthrough in the crisis with Syria after Russia proposed that its ally could hand over chemical weapons for destruction, offering a diplomatic path.
The development prompted investors to dump safe-haven assets, with borrowing costs over 10 years for Germany, France, Austria, the Netherlands and Belgium rising 6-7 basis points.
German Bund futures fell to a 1 1/2 year low of 136.80. They were last down 77 ticks on the day at 136.85, pushing 10-year yields 7 basis points higher to 2.025 percent.
They have risen nearly 90 bps since this year's lows and hit a 1-1/2 year high of 2.059 percent on Friday.
"At least what this means is that there could be further delays and even no military action at all. That scenario is at least opening up," Elwin de Groot, senior market economist at Rabobank said.
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