* Schatz yield hits lowest since mid-August * Expectations rise of ECB deposit rate cut * Italian political tensions push peripheral yields higher By Marius Zaharia LONDON, Dec 7 (Reuters) - German two-year bond yields dipped to four-month lows on Friday on bets the European Central Bank could cut interest rates further, but a pending U.S. jobs report kept investors cautious and limited falls. Italian yields rose after former prime minister Silvio Berlusconi's party withdrew support on Thursday for his successor Mario Monti, a technocrat who investors are relying on to bring down the country's debt. Also on Thursday ECB president Mario Draghi said the bank discussed the possibility of cutting its deposit facility rate to below zero. Some money market rates turned negative in a sign that investors saw a deposit rate cut as more likely than previously. A negative rate would penalise banks for depositing money with the ECB and, policymakers hope, force them to put their money to work elsewhere. Two-year German yields fell as low as minus 0.061 percent, their lowest since mid-August and meaning investors buying the assets are paying for the privilege of parking their money in a safe haven. "They (the ECB) wanted to open the door for a rate cut," said Marius Daheim, chief strategist at Bayerische Landesbank. "We've seen two-year yields at minus 0.1 percent earlier this year. I guess they can fall to that level again but we speak to clients and we ask whether they would buy German debt at negative yields and most of them say they wouldn't." Two-year German bonds have been in high demand this year for their relative safety. But ten-year German sovereign yields nudged higher to 1.30 percent, with one trader saying the U.S. non-farm payrolls report due at 1330 GMT offered a good excuse for investors to book profits on a recent rise in Bund prices. Lloyds strategists said they expected Bund yields to fall towards 1.20 percent in the near term on the ECB's monetary easing signals. If the U.S. jobs data is weak, Treasuries might rise on increased expectations of further monetary easing by the Federal Reserve and that could also drag Bunds higher. With superstorm Sandy having disrupted U.S. economic activity, payrolls in November are seen rising only by 93,000, compared with October's gain of 171,000, a Reuters survey showed. The unemployment rate is seen steady at 7.9 percent. "The hurricane impact may put a question mark over the numbers," another trader said, adding that this could limit market reaction. ITALIAN POLITICS Italian 10-year yields rose 5 basis points to 4.61 percent. The People of Freedom party walked out of a Senate confidence vote on Thursday after one of Monti's ministers said Berlusconi's potential return to politics may harm Italy. Monti's government survived the vote comfortably but it remained at risk of falling as tensions rose between the parties that have backed him over the last year. "Italian politics are inconclusive and fluent. There is a case for a bit more risk aversion," Commerzbank rate strategist Rainer Guntermann said, adding that this should take Bund futures to 146.00 by the end of the session. The March 2013 Bund future was six ticks lower on the day at 145.63, having jumped by more than a point in the past two sessions.