* Italian, Spanish politics watched closely
* German five-year debt sale seen going smoothly
* Markets, especially in periphery, could face volatility
By Marius Zaharia
LONDON, Feb 6 (Reuters) - Bunds edged up on Wednesday before a sale of five-year German debt that is expected to find strong demand after a recent rise in yields and worries about political stability in Spain and Italy.
Five-year German yields have more than doubled this year on expectations that excess liquidity in the banking system will shrink faster than initially thought as banks are repaying large sums in emergency loans to the European Central Bank.
Higher yields, as well as renewed demand for safe-haven assets sparked by a corruption scandal in Spain putting Prime Minister Mariano Rajoy under pressure and, in Italy, a rise in pre-election polls for former premier Silvio Berlusconi, are expected to support German debt in the near term.
Italian and Spanish bonds sold off sharply at the start of this week, and even if they showed signs of stabilising after Tuesday’s better than expected euro zone business surveys, analysts say selling pressure may return soon.
“Market participants see the risk that the Rajoy government can collapse on this scandal and you can’t know whether the next person will have the courage to continue (his reforms),” said Marius Daheim, chief strategist at Bayerische Landesbank.
“Also you can’t ignore that Berlusconi has said that if his party comes to power there will be no more austerity ... On the other hand the economic picture seems to brighten up and (the ECB’s new bond-buying programme) is still providing a backstop.”
He said the mixed picture would keep Bund yields stuck in their narrow recent range of 1.63-1.72 percent and Spanish yields in a wider 5.00-5.50 percent band near-term, while investors await more conclusive political developments.
Bund futures were last 16 ticks higher on the day at 142.36, with 10-year yields down 1.3 basis points at 1.65 percent and five-year yields falling 1.4 bps to 0.70 percent.
Italian and Spanish bonds were steady across all maturities, with their 10-year benchmarks trading at 4.47 percent and 5.39 percent, respectively.
Commerzbank strategists described the recent stabilisation as the potential “calm before the periphery storm” and recommended investors sell Italian and Spanish bonds.
The uncertainty should bode well for Germany’s sale of up to 4 billion euros of five-year debt later in the day. Positioning for the ECB’s rate-setting meeting on Thursday was likely to support demand at the auction as well, analysts said.
A rise in money market rates following the loan repayments to the ECB and worries that the euro currency’s strength may hurt the economy make many investors wary that ECB President Mario Draghi will be more open to easing monetary policy.
The central bank is seen keeping the key rate unchanged at 0.75 percent, but investors will be looking for hints in Draghi’s speech following the meeting.
“The front end of the (German) market may be supported going into the ECB just on hopes that he (Draghi) may soften his tone to address the currency,” one trader said.