Italian bonds outperform, all eyes on Fed
* Italian bonds outperform before Berlusconi vote
* German bonds rise as investors bet on "dovish" Fed
* Fed expected to announce $10-15 bln taper
By Ana Nicolaci da Costa
LONDON, Sept 18 (Reuters) - Italian bonds outperformed on Wednesday ahead of an appearance by Silvio Berlusconi expected to steer his political allies away from moves to bring down the government.
European bonds, including benchmark German Bunds, all crawled higher, reflecting expectations the U.S. Federal Reserve will make only a modest reduction in its bond-buying programme in a long-awaited statement at the end of the European day on Wednesday.
Italian bonds, while underperforming euro zone peers amid nerves around a fragile ruling coalition, have been guided more by the ebb and flow of Fed policy expectations since April.
"Investors are hopeful that he will try to be more diplomatic and the coalition will remain in place and that clearly would be good news for Italian government bonds," Nick Stamenkovic, bond strategist at RIA Capital Markets said.
But he added: "You never know with Mr. Berlusconi, he can surprise the markets in either direction."
Ten-year Italian yields were down 4 basis points at 4.37 percent, below Spain's 4.39 percent. Spanish bonds underperformed in comparison with Italian ones ahead of a debt sale on Thursday.
The previous session had seen Italian yields fall back below Spain's having overtaken them for the first time in 18 months last week.
Political sources said Berlusconi was expected to step back in his message from weeks of threats to sink the right-left coalition government of Prime Minister Enrico Letta if the Senate votes to expel him from parliament over a tax fraud conviction.
Sources in Berlusconi's PDL party said the pre-recorded message would now be transmitted on Wednesday, just before a Senate committee is due to take a preliminary vote.
"If (the coalition) is going to stay together at least for the rest of this year, then the market should see a bit of a relief and hence Italian bonds will benefit against the Spanish," Stamenkovic said.
Latest Reuters polling of economists shows a consensus for the Fed tapering by a modest $10 billion compared to $15 billion in August, although there were a variety of views in the market for how high a figure was priced in.
One bonds trader said anything above $20-$25 billion would trigger a sell-off but there are also expectations it may deliberately steer the market with language pushing back the prospect of a rise in interest rates far into the future.
"People have been waiting for the Fed for a long time and will wait to see what they say before they really dive in," the trader said. "You just feel people are thinking that (Fed Chairman Bernanke) might be a bit dovish so maybe that's a risk."
German Bund futures were 13 ticks higher at 138.20 but stuck to an 18-tick range. Ten-year yields were 1.1 basis points lower at 1.91 percent, off 1-1/2 year high of 2.059 percent hit earlier this month.
"The Fed will ... (signal) that they are slowly but surely aiming towards normalization of monetary policy. And against that backdrop, I find it hard to see Bund yields holding below 2 percent near-term," Stamenkovic added.
Two-year German yields were flat at 0.19 percent before a Schatz sale.