EURO GOVT-Bunds rise as German debt sale finds strong demand
* Italian, Spanish politics watched closely
* German five-year debt sale finds strong demand
* Markets, especially in periphery, could face volatility
LONDON, Feb 6 (Reuters) - Bunds firmed on Wednesday, with a five-year debt auction pointing to strong demand for assets perceived as safe havens after a recent flare-up of concern over political stability in Spain and Italy.
The sale was also helped by this year's rise in yields due to expectations that excess liquidity in the banking system will shrink faster than initially thought as banks repay large sums in emergency loans to the European Central Bank.
Investors snapped up 3.27 billion euros of the paper at an average yield of 0.68 percent, 15 basis points higher than when it was first launched in February.
"Today's good demand at the five-year auction is a sign that the recent political instability in the (euro zone) periphery played a major role in re-direction of some flows into safe-haven paper," said Annalisa Piazza, market economist at Newedge strategy.
In Spain, Prime Minister Mariano Rajoy is facing pressure to quit due to a corruption scandal, in which he denies any wrongdoing. In Italy, former premier Silvio Berlusconi is gaining ground in pre-election polls, raising worries the recent progress in structural reforms there could be reversed.
Robin Marshall, fixed income director at Smith and Williamson securities, said the lack of prospects of further easing in ECB policy at a time when other major central banks are printing large amounts of money also made German debt attractive from a currency perspective for overseas investors.
"There's not a great deal of value in the short-end yield-wise but with the currency strength you could argue there's reasonable value ... and if things do blow up (in the periphery) then Bunds should be fine," said Marshall, who helps manage about $18 billion.
The ECB meets on Thursday and debt traders said they would watch for any sign President Mario Draghi may soften his tone on monetary policy given the recent strength in the euro currency.
Bund futures were last 37 ticks higher on the day at 142.57, with 10-year yields down 3 basis points at 1.63 percent and five-year yields falling 2.3 bps to 0.685 percent.
Italian and Spanish debt were steady across all maturities, with their 10-year benchmarks trading at 4.50 percent and 5.39 percent, respectively.
Both sets of 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.
Commerzbank strategists described the recent stabilisation as the potential "calm before the periphery storm" and recommended investors sell Italian and Spanish bonds.