* Greek yields hit highest in nearly 2 months before retracing
* Greece considering scrapping controversial tax liability
* Government fragility evident ahead of EU elections (Recasts with late moves)
By Marius Zaharia
LONDON, May 16 (Reuters) - Greek bond yields rose to their highest in nearly two months on Friday as the tiny market was hit for a second day by uncertainty over a tax on foreign holders of Greek debt and the stability of the government going into EU elections.
Two finance ministry sources told Reuters that Greece planned to scrap the tax liability on capital gains for foreign holders of Greek bonds booked over 2012-2013, aiming to soothe investor fears that Athens was planning to collect the tax retroactively.
Such fears caused Greek 10-year yields to rise by half-a-percentage point on Thursday and another 15 basis points on Friday to reach 6.97 percent, their highest since March 21.
Yields fell slightly late in the day, but they were still 5 bps up on the day at 6.88 percent, with traders saying a government move to scrap the tax liability would not immediately draw back investors who exited Greece this week.
"It doesn't take much more than a combination of strange news and yield levels which many consider quite low to spark an exiting of trades," said David Schnautz, rate strategist at Commerzbank.
"The market seems to have calmed down a bit. But it's still a bit shaky and for Greece, with EU elections coming up the next couple of sessions could be ... volatile."
Investors see next week's European parliament elections as a risk because a strong showing of support for Greek opposition parties may weaken the already fragile ruling coalition and potentially pave the way for national elections.
Some of the Greek parties are against the bailout programme agreed with international lenders.
"The state of the government is at risk if a majority vote for parties that do not support the reforms agreed by the government," said Gianluca Ziglio, executive director of fixed income research at Sunrise Brokers.
Greek yields have fallen steadily by more than 250 bps since the start of the year, but analysts fear a reversal which started with some hedge funds selling bonds could prove to be more than just a blip.
"If volatility regains momentum, then the risk assessment for other investors may change," BNP Paribas strategist Patrick Jacq said.
The jitters in Greece sparked a rise in yields in the rest of the euro zone periphery. Portuguese 10-year yields were last 7 bps higher on the day at 3.792 percent.
However, in Italy and Spain buyers reappeared after yields surpassed 3 percent. Spanish yields were 5 bps down on the day at 2.96 percent and Italian yields fell 2 bps to 3.06 percent.
"Portugal and Greece are very illiquid markets, but Spain and Italy are in a much better shape technically," said Commerzbank's Schnautz. "Today's session, the fact that they rebounded, should increase confidence in those markets." (Additional reporting by John Geddie; Editing by Susan Fenton)