* Italian auction sees strong demand as yields rise
* Post-election uncertainty seen keeping pressure on Italy
* German debt gains as markets remain risk averse
By Marius Zaharia
LONDON, Feb 27 (Reuters) - Lower-rated euro zone bonds stabilised on Wednesday after an Italian debt auction drew ample demand, albeit at sharply higher yields, after an electoral stalemate there prompted a sell-off early in the week.
The relief may be short-lived, however, as investors continue to fret about Italy’s ability to reform its indebted economy following the weekend poll, which showcased the lack of popular support for austerity and resulted in a hung parliament.
Italian 10-year yields had shot 50 basis points higher as the election results emerged, taking them to around 4.90 percent - enough to persuade some, mainly domestic, investors to snap up the cheapened paper at auction.
Italy sold a maximum planned amount of 6.5 billion euros in five- and 10-year bonds, with demand higher than at a previous tender. Its 10-year cost of funds was the most since October, however, at 4.83 percent.
“The auction went relatively well so probably the fact that yields approached 5 percent triggered some demand,” BNP Paribas rate strategist Patrick Jacq said.
“Italy remains quite fragile, the bid for safety remains intact, but ... (the yield) is relatively attractive.”
Highlighting the ongoing worries about the uncertain political outlook, a post-auction dip in Italian 10-year yields to 4.82 percent reversed within minutes. Similarly, safe haven Bund futures bounced off session lows of 144.81 to last trade 33 ticks higher on the day at 145.23.
Traders said demand at the Italian debt sale was likely to have been supported mainly by domestic accounts, while foreign funds used the brief post-auction market cheer to sell more peripheral debt and buy low-risk instruments.
“We rule out (that) foreign accounts have played a major role at today’s auction as political risks remain high,” said Annalisa Piazza, market economist at Newedge.
Investec fixed income analyst Elisabeth Afseth expected 10-year Italian yields to rise above 5 percent and stay there unless political parties “surprise us and come up with a workable parliamentary solution.”
“I’d be happier to sit with core bonds with low yields for the next month or two,” she said.
If prolonged, the political deadlock could create a new wave of contagion in the euro zone, seven months after European Central Bank President Mario Draghi won some respite with his pledge to do “whatever it takes” to save the euro.
The ECB’s bond-buying programme (OMT) is still seen as a force acting against debt costs reaching unsustainable levels. But it requires countries to first apply for aid and then stick to an agreed programme of austerity, raising questions about how soon it could be activated.
“Italy has reminded everyone that triggering the OMT ... is not as easy as the market thought,” said Gilles Moec, economist at Deutsche Bank. “As it is a reminder of the fragility of the entire system, it has a negative impact for the risk premium for the entire periphery.”
“Now, is it enough to send us into the kind of mayhem in which we were last summer? No. It raises the bar for ECB intervention but it doesn’t kill the idea.”
Italian 10-year yields are still well below last July’s highs of about 6.7 percent. Spanish, Portuguese and Irish yields, which have been dragged up by Italy this week, were also stable on Wednesday, far below last year’s highs.
While peripheral markets were expected to remain under pressure, panic selling was unlikely, analysts said.
“It has some impact on other peripheral debt, but clearly the world has changed since the ECB decided on the OMT,” said BNP Paribas’ Jacq, who was less concerned about the anti-austerity vote in Italy.
“Do you know one country where people are voting for austerity?”