Political turmoil lifts Italian yields above Spain's for 1st time in 18 months
* Italy yields rise above Spain's, 1st time since March '12
* Concerns over immediate military attack vs Syria recede
* Safe-haven bonds fall sharply, periphery benefits
By Ana Nicolaci da Costa and Marius Zaharia
LONDON, Sept 10 (Reuters) - Italian government bond yields rose above Spain's for the first time since March 2012 on Tuesday on concerns about the survival of Rome's fragile government coalition.
Both Italian and Spanish bonds outperformed higher-rated debt as worries over a U.S. military attack on Syria ebbed, pushing Bund yields close to their highest in 1-1/2 years.
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 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 late on Tuesday after an initial meeting on Monday.
Italian yields last traded above Spain's for a period of seven months from August 2011, towards the end of Berlusconi's last term in power, when markets feared his policies could not keep a 2 trillion euro debt pile in check.
"Throughout the crisis Italy got whacked because of concerns over policymaking, especially during the dying days of the Berlusconi era," said Chris Scicluna, head of economic research at Daiwa Capital Markets. "At the moment what's driving the spread is (again) the political situation."
Ten-year Italian yields rose 2.6 basis points to 4.554 percent, while equivalent Spanish yields fell 1.3 bps to 4.532 percent.
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 board member Ignazio Visco said as much on Tuesday, warning political instability could unsettle financial markets.
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," he said.
Scicluna said that as the global economy recovers, Spain has a good chance of shrinking its budget gap and it can also expect its banking system to stabilise, whereas Italy's debt at 1.3 times its economy would be harder to bring down meaningfully.
Therefore, the fundamental concerns that pushed the two countries to the forefront of the debt crisis are more likely to subside in Spain, potentially giving Madrid a more prolonged period of outperformance in the debt market, he said.
Investors dumped safe-haven bonds as Syria accepted a Russian proposal to give up chemical weapons to avoid a possible U.S. military strike.
U.S. President Barack Obama, who called the proposal a potential breakthrough, would still proceed with a vote in Congress to authorise force, but the vote now appears more about providing a hypothetical threat to back up diplomacy.
The development prompted investors to dump German Bunds, with 10-year German yields rising to as high as 2.045 percent, some 9 bps up on the day and close to the 1-1/2 year highs of 2.059 percent hit last week.
Borrowing costs over 10 years for France, Austria, the Netherlands and Belgium also rose 7-8 bps. Bund futures closed 89 ticks lower at 136.73.
"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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