UPDATE 2-Renewed Italian government tensions fuel bond selloff

* Italian 2, 5 yr yields rise over 20 bps in early trade

* Key Italian govt officials due to meet on budget

* NFPs due later in day, U.S. 10-yr yield below 3 pct (Adds quotes, graphics, Monte dei Paschi result, updates prices)

LONDON, Aug 3 (Reuters) - Short-dated Italian government bonds sold off on Friday for the second straight day on signs of deepening tension within the Italian government that are raising the prospect of new elections.

Ministers are expected to meet later in the day to discuss Italy's budget for next year, two sources told Reuters, as the government remains split about its spending plans.

Economy Minister Giovanni Tria is under pressure from within the government to ramp up spending and challenge European Union budget rules.

The possibility that he might be forced to resign has investors worried that Italy could go on a spending binge, or even that new elections could be triggered.

"Clearly, this is about the fear that Tria gets kicked out, which could lead to a collapse of the government, new elections, and the League gaining even further," said Commerzbank strategist Christoph Rieger.

"Or it may mean that they agree on a budget that's at odds with the EU, and plus just the pure supply effect of more borrowing."

Italy's two-year and five-year government bond yields rose 25 basis points at one stage to eight-week highs before settling at 1.11 percent and 2.18 percent respectively, higher about 14 bps each on the day. .

Yields on 10-year bonds also rose, by 9 basis points, to hit 3 percent for the first time since June 11 before dipping slightly to 2.98 percent, and the closely watched spread over Germany was at its widest since late June at 255 bps .

Italian five-year CDS, meanwhile, was up 16 bps from Thursday's close to a near-two-month high of 242 bps, according to data from IHS Markit.

Meanwhile, Spanish five-year CDS rose to its highest since July 2 at 69 bps and Portugal to its highest since June 28 at 105 bps.

"There isn't a huge amount of common ground between the two (coalition) parties and the potential for them to upset their European Union colleagues is very high," said Eoin Walsh, founding partner and portfolio manager at Twenty Four Asset Management, a bond fund with £13.5 billion of assets under management.

The fund added Italian BTPs in June after the initial spike wider in spreads and currently holds two-year and five-year debt. Walsh said he is waiting to see how the budgetary discussions proceed before acting on this position.

Also putting pressure on Italian yields is concerns over how rising Italian borrowing costs could affect the country's banks, which hold large amounts of government debt.

Shares in the Italian post office fell nearly six percent on Thursday and on Friday Monte dei Paschi di Siena shares fell 8 percent at one stage.

"The very high volatility in Italian BTPs is hurting the banks because of the high ownership of Italian government debt among banks, and it is increasing the contagion effect between the public and the banking sector," said Natixis fixed income strategist Cyril Regnat.

The United States later on Friday will release non-farm payrolls data, which could affect higher-rated euro zone bonds.

The yield on 10-year U.S. Treasuries hit 3 percent this week, then receded to 2.97 percent, as an escalation of trade tensions between the United States and China sent investors rushing for the safety of government debt.

Most high-grade euro zone bond yields were also lower on the day, with benchmark German 10-year government bond yields down 3 bps at 0.43 percent.

(Reporting by Abhinav Ramnarayan; Additional reporting by Virginia Furness; editing by Sujata Rao and Angus MacSwan)