* Italian, Spanish politics under the microscope
* German five-year debt sale draws strong demand
* Thursday’s Spanish debt sale seen key for periphery
* Markets, especially in periphery, seen choppy
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Feb 6 (Reuters) - Bunds rose on Wednesday, with a five-year German debt auction pointing to strong demand for assets perceived as safe havens after a flare-up of concern over political stability in Spain and Italy.
The firmer tone in Bunds looked set to extend into Thursday with investors edgy over how well a Spanish auction of up to 4.5 billion euros of bonds will go in a market rattled by a corruption scandal that has cast doubt on Prime Minister Mariano Rajoy’s future.
The German sale was also helped by this year’s rise in yields due to expectations that excess liquidity in the banking system will shrink faster than initially thought as banks repay large sums in emergency loans to the European Central Bank.
Investors snapped up 3.27 billion euros of the paper at an average yield of 0.68 percent, 15 basis points higher than when it was first launched in February.
“Today’s good demand at the five-year auction is a sign that the recent political instability in the (euro zone) periphery played a major role in re-direction of some flows into safe-haven paper,” said Annalisa Piazza, market economist at Newedge strategy.
Bund futures climbed 34 ticks to settle at 142.54 with German 10-year bonds yielding 1.63 percent, 3 basis points down on the day, while five-year bond yields were 2.5 bps lower at 0.68 percent.
The Bund future this week bounced off three-month lows as a rally in peripheral euro zone bonds fizzled out with investors focusing uneasily on Madrid and Rome.
In Spain, Rajoy is facing pressure to resign over the corruption scandal in which he denies any wrongdoing, while in Italy former premier Silvio Berlusconi is gaining ground in pre-election polls, raising worries the recent progress in structural reforms there could be reversed.
Against that backdrop, some analysts expect Spain’s sale of 2015, 2018 and 2029 bonds on Thursday to struggle to meet the kind of stellar demand it has drawn at auctions so far this year.
“This (Spanish auction) has the potential to influence market direction,” said David Keeble, global head of fixed income strategy at Credit Agricole in New York.
“It’s going to be tougher than we’ve been used to given the volatility that seems to have come back in both directions (for Spanish bonds).”
Spanish 10-year yields rose 6 basis points to 5.44 percent, well within sight of a six-week peak of 5.51 percent hit early this week while equivalent Italian yields were up 7 bps at 4.55 percent.
Robin Marshall, fixed income director at Smith and Williamson securities, said he was wary of buying Italian and Spanish bonds at current levels, given nagging questions about reforms and the political outlook.
“We need to see a back-up to 6-6.5 percent in yield levels and if we see any problems with systemic institutions, debt trap, lack of reforms or popular ... (unrest), the moves can be quite dramatic,” said Marshall, who helps manage about $18 billion.
“Those levels would be interesting (for us to go back in Spain and Italy) but it depends on what happens. You need to see the context, if the same people are going to be in the government and how the economy is doing,” he said.
Besides the Spanish auction, market focus will be on the ECB meeting on Thursday and debt traders said they would watch for any sign President Mario Draghi may soften his tone on monetary policy given recent strength in the euro currency.
Marshall said the lack of prospects of further easing in ECB policy at a time when other major central banks are printing large amounts of money also made German debt attractive from a currency perspective for overseas investors.