* President's re-election could end Italian political impasse
* Italian debt gains, drags up rest of periphery
* German Bunds dip but rate cut bets limit losses
By Emelia Sithole-Matarise
LONDON, April 22 Italian bonds rallied on Monday, outperforming low-risk German Bunds, with more gains seen in the near term after the re-election of Italy's president raised the prospect of an end to two months of political stalemate.
A broad agreement between traditional political groups on the left and right to re-elect Giorgio Napolitano handed the 87-year-old the leverage to pressure opposing parties in Italy to form a government or face a snap election.
Italian BTP futures were a full point up at 114.02 while 10-year cash yields fell 12 basis points to 4.10 percent, around their lowest level since the end of January. Other peripheral euro zone bond yields fell in their wake.
"The near-term reaction is positive for Italy and to some extent for all peripheral markets. However, things are not settled yet and the risk of an early election favouring (ex-premier Silvio) Berlusconi has not disappeared completely," said Patrick Jacq, a strategist at BNP Paribas.
Italy has been in the grip of political uncertainty since inconclusive general elections in February. Nevertheless, the country's bonds have been resilient with investor concerns that a prolonged political impasse could re-ignite the region's debt crisis tempered by the European Central Bank's debt buying backstop and loose monetary policy by major central banks.
"In the current scenario of accommodative monetary policy, the Italian debt remains very attractive in terms of carry versus other EMU core debt where record low yields are far less attractive," Annalisa Piazza, market economist with Newedge Strategy said in a note.
A hunt for higher returns spurred in recent weeks by the Bank of Japan's huge stimulus plans has also driven down euro zone debt yields.
Spanish 10-year yields were down 8 bps at 4.57 percent, with Portuguese equivalents down 12 bps at 5.98 percent, breaking below 6 percent for the first time since late January.
Portuguese borrowing costs have held steady in the face of growing public protests against austerity, suggesting investors still believe the European Union will make the country's bailout work.
"We see flows coming from European domestic buying at the moment. Going to (yield) lows we reached this year will probably offer a pretext for some profit taking but the situation is still favourable to peripherals," BNP's Jacq said.
At the upper end of the credit spectrum in the euro zone debt market, German Bunds held largely steady, with investors wary of taking big positions before key manufacturing data on Tuesday expected to show growth remained anaemic in the euro zone, cementing market bets of a cut in official interest rates.
The Bund future was last 5 ticks up on the day 146.08 German 10-year yields were flat at 1.25 percent.
The Bund contract came off the day's low of 145.72 after ECB Vice President Vitor Constancio was quoted as saying inflation in the euro zone was coming down "rather significantly", important when the central bank decides whether to cut rates.
"The ECB tone has been pretty dovish...they are telling us that they are lining up for a rate cut," a trader said.