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Risk aversion fuels sell off in Italian bonds

Virginia Furness

* Italian 10-year govt bond yields rise to 2-1/2 month highs

* Italy/Spain 10-year yield gap near widest since mid-Feb

* Ten-year German bund yield flat on trade talk uncertainty

LONDON, May 13 (Reuters) - Italian government bonds yields rose to their highest level in 2-1/2 months on Monday as risk aversion due to political infighting and a warning from the European Commission on Italy's public finances fuelled a sell off.

Infighting within Italy's ruling coalition, a warning from the European Commission that public finances would deteriorate further and politicians raising the possibility that Italy could breach EU rules on public spending have unnerved investors.

Trade tensions between the U.S. and China also compounded the lack of risk appetite and saw Germany's 10-year government bond, the benchmark for the region held around -0.05% and were last flat on the day.

Italian 10-year government bond yields rose 13 basis points last week, extending this rise in early trade on Monday, and underperforming its peers. It was last up three basis points at 2.71%. Last week's sell off was the biggest in three months.

The Italy/Spain 10-year bond yield gap held close to its widest since mid-February and was last seen at 171 basis points .

Italy's coalition government vowed last week to patch up their differences and govern for four more years after a corruption scandal created fierce tensions. But support for Italy's far right League party has fallen following the weeks of feuding with its coalition partner the 5-Star Movement, opinion polls showed on Friday in the run-up to elections for the European Parliament in late May.

Commerzbank rates strategist Rainer Guntermann cited the political news flow and fear over the rising deficit for the sell-off, but noted that the budget discussion will likely be postponed until after the European elections.

"The Commission is in a vacuum ahead of the election...and this will heat up later this year when we get the official reporting in Europe," he said.

The European Commission last week cut Italy's growth forecast to 0.1%, down from 0.2%, and said the country's deficit could widen beyond the three percent ceiling set by the European Union.

Italy's government tested investor patience, as well as that of the EU, last year by trying to push through an expansive budget which breached EU deficit rules.

Lawmakers are once again mounting a challenge to EU fiscal rules. Italy's Deputy Prime Minister Luigi Di Maio said on Friday the European Union's fiscal rules should be changed to allow more public spending on health, research and education.

In an interview with La7 television channel, Di Maio said the EU's budget deficit ceiling of 3 percent of gross domestic product "is okay for certain things but spending on education, health and research have to come out of the calculation."

Adding to woes is Rome's attempt to avoid a bail-out of troubled lender Carige after U.S. fund manager BlackRock pulled out of its rescue.

Investors will be able to have their say on the outlook for Italy on Tuesday, when its Treasury auctions up to 6.75 billion euros of bonds.

(Reporting by Virginia Furness Editing by Raissa Kasolowsky)