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UPDATE 2-Italy in the limelight as ECB policy, bank rescue cloud picture

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates closing prices)

LONDON, July 5 (Reuters) - Investors scrutinised the outlook for Italian bond yields closely on Wednesday after the European Central Bank bought more of that country's debt than usual in its flagship asset-buying programme.

The ECB bought more than 2 billion euros of Italian and French bonds than it was supposed to in June, moving further away from a rule aimed at ensuring that its stimulus is evenly spread across the euro zone.

The conflict for investors is that Italy, one of the biggest beneficiaries of the ECB's bond buying scheme, is expected to be amongst the biggest losers as the central bank unwinds its extraordinary stimulus.

However, if the ECB is going to buy more Italian bonds than expected in the months to come, that could soften the blow.

"It is very hard as an investor to know whether to buy or sell on this news," said DZ Bank strategist Christian Lenk.

"At the end of the day, if the ECB is approaching its limit of (German) Bunds (it can buy), we may see a stronger deviation towards (Italian) BTPs. But it is still a relatively small amount of deviation so far and the overall picture is of tightening."

The gap between Italy's 10-year government bond yield and the German equivalent shrank to 163 basis points, its narrowest in over two weeks, 40 bps less than the April peak .

It also emerged Tuesday that the European Union had approved a 5.4 billion-euro state bailout of Italy's fourth-largest lender, Monte dei Paschi di Siena, taking the total amount of Italian taxpayer funds deployed to rescue banks over the past week to more than 20 billion euros.

Euro zone government bond yields have been rising across the board in recent weeks on comments from policymakers that suggest the ECB is moving towards normalising its ultra-loose monetary policy stance.

Though some policymakers have since sought to play this down, German government bond yields are close to their highest levels all year. In late trade on Wednesday, Germany's 10-year bond yield was flat at 0.47 percent.

Volatility in euro zone bond and currency markets over the past week has not been significant and partly reflects a misalignment between bond and equity prices, European Central Bank board member Benoit Coeure said on Wednesday.

Minutes of the ECB's June meeting are due on Thursday, which should provide further clues on how far the tapering debate has gone in Europe.

The U.S. Federal Reserve is also due to publish minutes of its June 14 meeting later on Wednesday, with analysts waiting to see if the Fed drops any hints on whether it will push its next rate increase to later in the year.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.bi z / c m s / ? p a g e I d = l i v e m a r k e t s

(Reporting by Abhinav Ramnarayan; Editing by Larry King)