* Italy's Letta names government, ends political stalemate
* Italian, Spanish government bonds rally
* Bunds dip, losses limited by ECB rate cut expectations
By Marius Zaharia
LONDON, April 29 (Reuters) - Italian bond yields fell on Monday and were expected to ease further as a two-month-old political deadlock came to an end after new Prime Minister Enrico Letta named a coalition government.
The country sold debt at the lowest cost since Oct. 2010 at an auction on Monday, meeting stronger demand than at previous sales.
Letta, of the centre-left, was expected to win parliament's backing in a confidence vote at 1300 GMT. He relies on the support of his centre-right rivals, led by former premier Silvio Berlusconi.
An inconclusive election in February left Italy, the euro zone's third-largest economy, without an effective government, threatening investor confidence and holding up reform efforts.
Italian 10-year yields were 12 basis points lower at 3.95 percent, some 273 bps more than benchmark Bunds. BTP futures were last 99 ticks higher at 115.40.
"On the very short-term the new government is supportive. The composition is quite mixed, with good representation of the main parties and some technocrats in the key ministries," said Annalisa Piazza, market economist at Newedge Strategy in London.
"There is a chance that markets will price in a long-lasting government ... of at least one year, which will be enough time to push through some reforms."
She said the Italian/German 10-year yield spread could narrow to 180-190 basis points over a three- to six-month period. Rabobank's senior rate strategist Richard McGuire also said the gap could tighten to about 200 bps.
Italy pulled other higher-yielding markets with it, with Spanish 10-year yields down 7 bps at 4.21 percent.
Demand for riskier assets has been strong this year, with investors aiming to maximise returns as abundant central bank liquidity drives rates lower across the board.
Some investors were reluctant to take new positions in Italy at the current level of 10-year yields, which is just off a 2-1/2 year low of 3.89 percent hit last week.
"We're moving towards a stabler electoral background ... this is good news," said Sanjay Joshi, head of fixed income for London and Capital - a group managing assets worth around $4 billion - which sold its Italian and Spanish debt holdings before the elections.
"But we haven't made any moves yet. Economic conditions in other euro zone countries have deteriorated."
Weaker than expected economic data in recent weeks have fuelled expectations of a European Central Bank interest rate cut at its meeting on Thursday. A 25 basis point move would take its key interest rate to a new record low of 0.50 percent.
Such expectations limited losses for German debt, which is treated as a safe haven and usually suffers when lower-rated debt rallies.
Bund futures were 12 ticks lower on the day at 146.42, while cash 10-year German yields were 1 basis point higher at 1.22 percent.