March 6, 2013 / 11:51 AM / 4 years ago

EURO GOVT-Italy rallies as ECB backstop trumps political crisis

* Italian bond yields fall for second day running

* Germany comfortably sells 3.1 bln euros of 5-yr bonds

* ECB meeting seen as key to appetite for German debt

By William James

LONDON, March 6 (Reuters) - Italian government bond yields fell on Wednesday as investors put their faith in the European Central Bank's ability to prevent inconclusive elections from driving Italy into full-blown crisis.

Investors bought back Rome's bonds for a second consecutive session despite expectations that attempts to form a coalition will fail, and with the country's president considering appointing a technocrat government.

Ten-year Italian bond yields were down 9 basis points at 4.65 percent as analysts pointed to the ECB's long-standing, but untested, promise to backstop struggling sovereigns by buying government bonds.

"At the moment the market is looking through everything and saying 'Italy is not going to be allowed to leave the euro zone and it's got too much debt to be allowed to default, so actually this is quite a nice-yielding asset'," said Lyn Graham-Taylor, strategist at Rabobank in London.

Italy's 10-year borrowing costs are now only 21 basis points higher than before the poll as an initial 50 bps rise has steadily been eroded.

The moves have been supported by a broadly more optimistic mood around the global economy thanks to signals from the United States, as well as expectations of another strong message from the ECB on Thursday on its determination to see out the crisis.

Despite the demand for higher-yielding bonds, ultra-low yielding Germany found plenty of willing buyers at an auction of five-year bonds which came at lower borrowing costs compared to a similar sale a month ago.

"It shows that even though investors are relatively sanguine about the Italian political outlook, the unclear picture in Italy and the continued weakness of the euro zone economy are providing good support for the German government bond market," said Nick Stamenkovic, strategist at RIA Capital Markets.

EXPENSIVE BOBLS

German Bund futures were four ticks higher on the day at 145.07 with the near-term outlook for core debt dominated by Thursday's ECB meeting, at which dealers increasingly believe the central bank will signal an accommodative policy outlook.

"We think they'll show they had a serious discussion on rates and with the new round of staff forecasts they may just pave the way for a cut," a trader said.

But, while that may encourage bonds broadly to rally in anticipation of lower rates, in the short term it may help keep investors in the mood to buy the euro zone's riskier debt in preference to Bunds.

"At the moment risk assets seem to take central bank dovishness on board more than bonds do," the trader said.

The strong demand for five-year debt supported the idea that markets were now wary of a rate cut. The bonds on offer had been seen as expensive relative to other maturities, but solid demand suggested buyers were happy to take on debt with the view that current yields would look attractive if rates did fall.

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