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UPDATE 1-Jittery investors cut Italian debt and head for safety

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 (Adds new quote, updates prices)

LONDON, May 13 (Reuters) - Italian government bonds yields rose to their highest level in 2-1/2 months on Monday as risk aversion caused by deteriorating U.S.-China trade talks and worries about more political infighting in Rome fueled a selloff.

Italian bond yields rose after last week's warning from the European Commission that public finances would deteriorate further and politicians in Rome raising the possibility that Italy could breach EU rules on public spending unnerved investors.

Analysts said they expected public discord between the two ruling Italian parties to grow in the run-up to European elections later this month, causing more volatility.

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 five basis points at 2.73%. 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 174 basis points .

Germany's 10-year government bond, the benchmark for the region, held around -0.05%, flat on the day after earlier falling as investors looked for safety.

China said on Monday it would never surrender to external pressure after Washington renewed its threat to impose tariffs on all Chinese imports in the escalating trade row.

"Bunds opened up fairly well bid. That was a clear impact of the further deterioration in the U.S. China trade talks," said Peter Chatwell, a strategist at Mizuho.

Longer-dated bonds are also sensitive to shifts in risk sentiment. Ireland's 2050 bond issued last week, for example, has been hit by market jitters and was last trading at a cash price of 98.30, translating to a yield of 1.566%.

Last Thursday, the Irish debt agency raised 4 billion euros from the 2050 issue at a cash price of 99.313 and a yield of 1.528%.


Investors are watching the Italian political situation closely after Italy's coalition government vowed last week to patch up their differences and govern for four more years.

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.

Commerzbank rates strategist Rainer Guntermann cited the political news flow and fear over the rising deficit for the selloff, 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 3% 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 a 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.

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; Additional reporting by Tommy Wilkes; Editing by Alison Williams)