* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates to include chart and further detail on Italy bond yields)
By Saikat Chatterjee
LONDON, July 22 (Reuters) - Benchmark Italian bond yields rose from three-year lows on Monday as investors geared up for a showdown between Italy’s coalition partners this week.
The far-right League and anti-system 5-Star Movement have been at each other’s throats for months, but tensions have risen even further, with each accusing the other of betrayal and bad faith.
League leader Matteo Salvini warned last week he would quit the government unless 5-Star dropped its opposition to projects close to his party’s heart, including a drive to hand greater autonomy to the League’s wealthy northern heartland.
After hovering near three year lows in early trade, a selloff in Italian government bonds gathered momentum as trading wore on and yields rose as much as 7 basis points to reach one-week highs,.
Italy’s 10-year bond yield pulled away from Germany as investors began to price in the greater risk, with the gap between the two widening to more than 200 basis points for the first time in 10 days, last at 199 bps. Italy’s 10-year was last yielding 1.67%.
Uncertainty over the future make up of the Italian government is pushing yields higher, said Daniel Lenz, rates strategist at DZ Bank.
“The problem is that political uncertainties have prevailed for a couple of days,” he said. “If (Prime Minister Giuseppe) Conte is replaced with someone closer to Salvini, people are concerned about more fiscal loosening.”
But some market strategists say the confrontational tone adopted by Salvini may be an excuse to extract greater concessions in budget discussions.
“We are less convinced that the coalition may be about to collapse, that is because Salvini knows he has a strong hand and that is what he is trying to exert currently with the prime minister and (coalition partner) Luigi di Maio,” said Matt Cairns, rates strategist at Rabobank.
Bond yields have dropped by more than 100 basis points since mid-June when ECB chief Mario Draghi flagged the bank was preparing to embark again on monetary stimulus.
But the bond rally came to a halt last week as political tensions took centre stage.
Conte was due to hold another round of consultations on Monday and has said he hopes to present a final proposal on the reform to a cabinet meeting pencilled in for Friday.
Elsewhere, core European bond yields paused for breath after posting their biggest weekly drop in seven weeks before a European Central Bank policy meeting this week where policymakers might unveil plans for more rate cuts.
Though hopes have grown that the ECB might cut its deposit rate as soon as Thursday to soften the impact on the euro from a much-awaited Fed rate cut, market watchers say policymakers will change forward guidance before taking further steps.
As a result, German bond yields for 10-year maturities were broadly steady at minus 34 bps in early London trading — within striking distance of a record low of minus 40 bps hit earlier this month.
Tensions between Britain and Iran over the seizure by Iran of an oil tanker are also set to sustain demand for safe-haven core European debt. ($1 = 0.8915 euros)
Reporting by Saikat Chatterjee; Additional reporting by Virginia Furness; Editing by Catherine Evans