Political turmoil drives Italian yields higher in thin markets
* Italian yields rise after centre-right threats
* Spanish/Italian yield spread at tightest since March 2012
* Italy returns to market this week after summer break
* German yields hover near highest in 1-1/2 years
LONDON, Aug 26 (Reuters) - Italian yields rose on Monday as a political showdown looms over Silvio Berlusconi, underperforming other euro zone bonds even as Italy prepares to return to the market this week after a summer break.
Berlusconi's centre-right party has threatened to bring down the government if its centre-left coalition partners vote next month to expel him from parliament after he was convicted of tax fraud.
Analysts warned against reading too much into market moves, with liquidity thinned by a UK public holiday and said the price action on Tuesday would better reflect investor sentiment.
Nevertheless, they say political uncertainty has helped narrow the premium that 10-year Spanish government bonds offer over their Italian counterparts to its lowest since March 2012, along with their differing supply plans.
"This reflects probably an idiosyncratic risk of the BTP market which reflects the political uncertainty," said Sergio Capaldi, fixed income strategist at Intensa SanPaolo.
While the improved economic backdrop has helped Italian bonds, he said Spanish debt markets have managed to benefit even more from a better outlook.
Ten-year Italian yields rose 7.5 basis points to 4.41 percent, widening its spread over equivalent German yields by 8 basis points to 248 bps.
The 10-year yield spread between Spanish and Italian bonds meanwhile was at 8 bps, its tightest in 1-1/2 years.
"I wouldn't read too much into it, tomorrow is more interesting ... but it looks as if the market is making slowly some room to be able to digest the supply," one trader said.
Analysts said the political backdrop could cast a shadow over a bond sale on Thursday. However, they expected politicians to find a last-minute deal to avoid a crisis, while Italy's comfortable funding position was expected to enable it to withstand any rise in yield.
German 10-year yields held near their highest in 1-1/2 years as an improved economic outlook continued to fuel concerns over the future of global central bank liquidity.
They were little changed at 1.93 percent, within sight of the 1.98 percent on Friday - the highest since March 2012.
U.S. durable goods data later on Monday will come in focus as markets seek clarity on whether the Federal Reserve will begin slowing bond purchases as soon as next month.
Commerzbank strategist Rainer Guntermann expected 10-year German yields to stay at 1.90-2.00 percent until next week's U.S. jobs data, which would be "decisive" for the tapering debate.
"What has been a bit of a burden for the market was simply the uncertainty about tapering. At current levels we could imagine that yields will find a bit of support, with the help of mixed data rather than positive data," Guntermann said.
German Bund futures were 11 ticks higher at 139.69, having fallen as far as 139.06 on Friday - its lowest since September 2012. Further downside was expected however.
"As the indicator situation is negative in both the weekly and daily charts, further losses towards the September 2012 low of 138.41 are possible this week," Helaba Landesbank Hessen-Thueringen said in a note.