* 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 William James and Marius Zaharia
LONDON, Feb 27 (Reuters) - Lower-rated euro zone bonds rebounded on Wednesday as buyers emerged to put the brakes on a major selloff set off earlier this week by Italy’s electoral stalemate.
Italian 10-year yields fell 9 basis points on the day to 4.81 percent, recovering some of the 50 bp rise seen on Tuesday after elections left the euro zone’s third largest economy struggling to form a government.
A closely watched Italian bond sale saw bidders tempted in by yields at their highest auction level since October, calming fears the paper would be difficult to sell given the volatile market environment.
“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.”
But, highlighting the ongoing worries, a post-auction dip in Italian 10-year yields reversed within minutes, and Bund futures - the bloc’s safe haven asset - remained in demand. Bund futures settled 19 ticks higher on the day at 145.09.
Traders said demand at the debt sale came mainly from Italian buyers and dealers covering bets that the market would fall. Foreign funds used the brief post-auction cheer to sell peripheral debt and buy low-risk instruments, the traders said.
The uncertainty over Italy was expected to drag on for weeks, possibly resulting in fresh elections, and so demand for lower-rated bonds was expected to remain in a state of flux.
“We’re in a vacuum of news at the moment,” said Chris Scicluna, head of economic research at Daiwa Capital Markets.
“We know there’s still the (European Central bank) in the background as a credible backstop so I don’t think there’s a case for panicking and equally I don’t think there’s a reason to be overly optimistic about the nature of Italian politics.”
If prolonged, the political deadlock could create a new wave of contagion in the euro zone, seven months after ECB 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 were dragged up by Italy this week, also recouped losses on Wednesday and sit 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?”