EURO GOVT-German debt rallies as Italy auction nerves set in
* German debt benefits as peripheral bond yields rise
* Italian bond yields rise before weekend election
* Market eyes data ECB loan payback later this week
LONDON, Feb 18 (Reuters) - German government bonds outperformed Italian and Spanish debt on Monday as investors turned to less risky assets before Italy's election this weekend.
The moves reflected uncertainty over whether Italy's Feb. 24-25 vote could fragment parliament and hamper the future government's reform efforts and market participants said these doubts were likely to weigh on Italian bonds throughout the week.
"Investors are afraid of uncertainty. The main risk is that we end up with a government that cannot operate because it's too weak," said Jan von Gerich, chief strategist at Nordea.
Italian 10-year bond yields rose 4 basis points on the day to 4.41 percent while equivalent German yields moved in the opposite direction, falling 3.5 bps to 1.63 percent.
Nevertheless, dealers reported only minimal activity behind the weak performance in Italy -- partly due to low trading volumes with the U.S. markets closed for a public holiday -- and yields remained well within their recent ranges.
This reflected investors' underlying confidence in the euro zone, in large part thanks to the European Central Bank's promise to buy bonds issued by struggling states if needed, said Michael Leister, strategist at Commerzbank in London.
"There still seems to be a lot of faith that the peripheral situation will remain under control, or well behaved," he said.
Spanish 10-year bond yields, which often move in tandem with their Italian counterparts, were 5 bps higher at 5.25 percent. Selling pressure in Spain also reflected investors making room on their books for a 3-4 billion euro debt auction on Thursday.
Credit Agricole strategists recommended favouring Spanish bonds over Italian debt near-term as "the possibility of an inconclusive result in the Senate is very real, even if not the central outcome, and that presents a significant and asymmetric tactical risk for BTPs (Italian bonds)".
German Bund futures rose 42 ticks on the day to 142.76, and were seen rising towards the top of their recent range just above 143.00 in the near term.
While Italy will dictate market sentiment this week, investors will pay close attention to economic data this week, including the German ZEW economic sentiment on Tuesday and flash euro zone Purchasing Managers Index surveys on Thursday.
On Friday, the European Central Bank will announce the amount of the second three-year emergency loans banks plan to repay.
A larger figure than the 125 billion euros consensus could push money market rates higher and increase selling pressure on short-dated German debt as it would lead to expectations that banking system excess liquidity might shrink rapidly.
On the other hand, it raises the risk that the ECB may feel its monetary policy is becoming less accommodative than it should be, bolstering expectations of central bank interest rate cuts, which should support Bunds.
(Editing by Nigel Stephenson)