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* Schatz yields hit lowest since mid-August
* Expectations rise of ECB depo rate cut
* Shaky Italian politics push periphery yields higher
By Marius Zaharia
LONDON, Dec 7 (Reuters) - German two-year bond yields dipped to four-month lows on Friday on bets the European Central Bank could cut interest rates further, but a looming U.S. jobs report kept investors cautious and limited falls.
Italian bond yields rose after former Prime Minister Silvio Berlusconi's party withdrew on Thursday support for his successor Mario Monti, a technocrat trusted by investors to bring down the country's debt.
The ECB sharply cut its forecasts for the euro zone economy, on Thursday and its president, Mario Draghi, said the bank discussed the possibility of cutting its deposit facility rate to below zero.
Some money market rates turned negative in a sign that investors saw a deposit rate cut as more likely than previously. A negative rate would effectively penalise banks for depositing money with the ECB and, policymakers hope, force them to put their money to work elsewhere.
"Short-term Germany (debt) remains supported on the negative rate talk. Longer-term maturities have rallied a lot and (U.S. non-farm) payrolls are the perfect excuse to book some profits," one trader said.
Two-year German yields fell as low as minus 0.059 percent, their lowest since mid-August. Ten-year yields nudged higher to 1.30 percent, but Lloyds strategist expect them to fall towards 1.20 percent near-term on rate cut bets.
Weak U.S. jobs data may lift Treasuries by increasing expectations of further monetary easing by the Federal Reserve and that could drag Bunds higher. However, market expectations are for a weak number.
With superstorm Sandy having disrupted U.S. economic activity, payrolls in November are seen rising only by 93,000, compared with October's gain of 171,000, a Reuters survey showed. The unemployment rate is seen steady at 7.9 percent.
"The hurricane impact may put a question mark over the numbers," another trader said, adding that this could limit market reaction.
Italian 10-year yields rose 9 basis points on the day -- the biggest rise among 10-year euro zone yields -- to 4.65 percent.
The People of Freedom party walked out of a Senate confidence vote on Thursday after one of Monti's ministers said Berlusconi's potential return to politics may harm Italy.
Monti's government survived the vote comfortably but it remained at risk of falling as tensions rose between the parties that have backed him over the last year.
"Italian politics are inconclusive and fluent. There is a case for a bit more risk aversion," Commerzbank rate strategist Rainer Guntermann said, adding that this should take Bund futures to 146.00 by the end of the session.
The March 2013 Bund future was five ticks lower on the day at 145.64, having jumped by more than a point in the past two sessions.
Guntermann expected Bunds to build on speculation about further rate cuts, but doubted the ECB will deliver them.
"For the time being and until the end of the year there is free room for some further speculation," Guntermann said.
"At the same time the ECB has published these very downbeat forecasts yesterday but decided not to change rates. This implies that the bar for a rate cut is quite high."