Italian yields rise as Berlusconi raises pressure on government
* Berlusconi raises pressure as Senate decision nears
* Italian debt resumes underperformance of Spain
* Bunds pare gains after lacklustre German debt sale
* But Syria crisis underpins demand for low-risk bonds
LONDON, Sept 4 (Reuters) - Investors stepped back from Italian debt on Wednesday, rattled by allies of Silvio Berlusconi threatening to bring down the government if the Senate voted to expel him following a tax fraud conviction.
Italy's 10-year yield premium over German Bunds widened 7 basis points to 248 basis points . The euro zone benchmark was underpinned by concerns about Washington edging closer to a military strike on Syria.
Senators from Berlusconi's People of Freedom party (PDL) met on Wednesday to discuss tactics and said the government could not continue if the Senate decides to strip Berlusconi of his seat in the upper house.
"It seems that Berlusconi is determined not to go down without a fight," said Alan McQuaid, chief economist at Merrion Stockbrokers in Dublin. "The problem is that the government ... can fall at any given time."
Italian bonds resumed underperforming Spanish debt even as investors made room in their books for Madrid's sale of up to 4 billion euros of bonds on Thursday.
One trader said the Spanish 10-year yields - last at 4.51 percent - could eventually fall below Italy's if the pressure on Prime Minister Enrico Letta's left-right government continued to build.
"We are going to get bellicose statements from Berlusconi's party in coming weeks and it could easily result in elections. The market won't really like that," the trader said.
The gap between the two shrank to its tightest in 1-1/2 years of 2 basis points last week, before the government reached a deal to scrap a controversial property tax which also threatened to destabilise the coalition. It was last at 10 basis points.
Underlying sentiment for top-rated Bunds remained firm, as concern over Syria outweighed this week's forecast-beating European and U.S. manufacturing data which reinforced bets the Federal Reserve would soon cut its bond purchases.
The U.S. Senate's Foreign Relations Committee agreed a draft authorisation on Tuesday for the use of force against Syria, paving the way for it to vote on Wednesday. President Obama also won the backing of key figures, including Republicans, for his call for limited U.S. strikes on Syria.
Bund gains were capped, however, by a weak German auction of 4 billion euros of new five-year bonds.
Bund futures closed 12 ticks higher at 139.73, off a session high of 139.96 reached before the German auction.
"One of the drivers behind this is likely to be market confusion over the opposing factors of (Federal Reserve) QE (quantitative easing) tapering and potential military action in Syria," Rabobank strategist Lyn Graham-Taylor said of the sale.
"The weak bid/cover indicates that the QE effect is currently predominating in the bigger picture."
German 10-year yields were 1 bp lower at 1.94 percent, not far off their 1-1/2 year high of 1.98 percent reached two weeks ago. Many analysts saw little scope for a significant decline in yields before a European Central Bank policy meeting on Thursday and U.S. jobs data on Friday.
"(The ECB) will keep their dovish line but probably won't do anything on rates," Merrion's McQuaid said.