Italy leads European shares lower on fear of new government crisis
* FTSEurofirst 300 down 0.5 pct, FTSE MIB down 2 pct
* Threat of government crisis fuels profit taking on Italian shares
* Morgan Stanley expects pullback of up to 10 pct as Fed tightens
LONDON, Aug 19 (Reuters) - Italian shares led European bourses lower on Monday as reports of a rift opening up in Rome's coalition government triggered some profit taking on the region's best-performing index in the past month.
Italy's FTSE MIB index fell 2 percent, as traders cashed in on its recent 14 percent rise, after reports that Silvio Berlusconi's centre-right party may withdraw its vital support from the government if he is expelled from the Senate following his recent conviction for tax fraud.
Prime Minister Enrico Letta warned on Sunday that the collapse of his government would undermine the nascent economic recovery in Italy, which has helped the FTSE MIB outperform all other indexes in the region in the past month.
Volume on the FTSE MIB was 114 percent of its 90-day average at 1509 GMT, compared to a meagre 57 percent for the pan-European FTSEurofirst 300, which fell 0.5 percent to 1,225.43 points.
"The market is betting that we're going to have a bout of uncertainty," said Ugo De Pasquale, an option trader with Qubed Derivatives.
"Italy needs the coalition government to stay in power. That's what the market is telling us."
Italian lenders UniCredit and Intesa Sanpaolo shed 4.5 percent and 3.3 percent, their biggest daily losses since June after hitting six- and 18-months highs on Friday.
Traders said a nearly 30 percent rally in Italian banking shares in the previous month, fuelled by some better-than-expected economic data against very low valuations, magnified the extent of the profit taking on Monday .
Short interest in Intesa Sanpaolo and UniCredit, a gauge of interest from speculative sellers, was hovering around a one-year trough last week, Markit data showed, and the cost of insuring against future swings in both stocks recently hit its low for the year, showing sentiment around the shares was at its most bullish.
Around Europe, Britain's FTSE 100 fell 0.4 percent, France's Cac shed 0.9 percent and Germany's Dax fell 0.2 percent.
Investors were positioning for a reduction in the U.S. Federal Reserve's asset-purchase programme, which along with other, similar central bank schemes around the world has helped the FTSEurofirst 300 rise 30 percent since June 2012.
Traders will look for hints on when the Fed might start cutting back its quantitative easing programme when the minutes of the July policy meeting are published on Wednesday.
"In the past, when markets started to price in a change in the monetary policy cycle, you tended to see a pause in the market or a bit of a correction," said Ronan Carr, a strategist at Morgan Stanley, who expected European indexes to pull back as much as 10 percent in the near term.
"It doesn't necessarily derail the favourable outlook which is defined by improving growth but we think it will cause some indigestion in the near term."