* Demand for Italian bonds improves at auction
* Berlusconi brings Italian politics back in focus
* Bund futures hit 142.00, then retreat
LONDON, Oct 30 (Reuters) - Italian government bond yields edged lower on Tuesday as improved demand at a debt auction showed investors were willing to overlook political jitters for the near-term.
Data showing the Spanish economy contracted a tad less than expected in the third quarter and renewed interest in selling safe-haven German Bunds at technically important levels helped to stabilise peripheral debt markets after a sell-off on Monday.
Former Italian Prime Minister Silvio Berlusconi threatened at the weekend to withdraw support for Mario Monti's technocrat government before elections in April. That swung investors' attention back to Italy as uncertainty over the timing of a Spanish aid request lingered.
Selling pressure did not continue beyond Monday, however, and Italy managed to sell 7 billion euros of five- and 10-year bonds on Tuesday, paying its lowest cost to borrow since May 2011.
``Berlusconi is seen as a loose cannon. It shows that the political picture in Italy is still pretty clouded, but I don't think it is affecting Mr. Monti's rule for now,'' RIA Capital Markets bond strategist Nick Stamenkovic said.
``It is really the European Central Bank driving sentiment at the moment and the expectation that it will come in and activate its bond-buying programme if Spain calls for a sovereign bailout.''
Italian 10-year bond yields were 4 basis points lower at 4.97 percent, having risen about 25 basis points in the last two weeks.
While the impact of internal political battles on bond markets was limited for now, pressure may increase on peripheral issuers in coming months as elections draw nearer, analysts say.
``With elections coming closer it will be more obvious that reforms have not been implemented ... and the real problem in Italy is politics. The periphery will suffer again,'' said Norbert Wuthe, rate strategist at Bayerische Landesbank.
He added that if political tensions in Italy intensified, increasing pressure on the euro zone periphery in general, Spain may have to ask for a bailout after regional elections in Catalonia in late November.
Spain remains reluctant to make the move, which is eagerly-awaited by markets as it will open the way for the European Central Bank's bond-buying programme, seen as capping peripheral yields.
Ten-year Spanish yields were steady at 5.66 percent. Spain's economy shrank 0.3 percent in July-September from a quarter earlier, less than the consensus for a 0.4 percent contraction.
German Bund futures were 20 ticks lower on the day at 141.50, having earlier risen as high as 142.00, a level at which traders noted renewed selling interest. Ten-year cash yields also bounced off a low of 1.45 percent, which was the 100-day moving average.
The selling pressure on Bunds ``was purely technical'', one trader said.
Trading was expected to be thin, with U.S. bond markets closed on Tuesday due to the storm Sandy battering the U.S. east coast.