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UPDATE 3-Italy inches closer to new cabinet as deadline approaches

Giselda Vagnoni and Angelo Amante

* 5-Star, PD expected to seal a deal on govt led by Conte

* Both sides will report to head of State later in the day

* Conte led the previous 5-Star/League coalition (Adds market reaction)

ROME, Aug 28 (Reuters) - Tense talks aimed at forming a new Italian government inched forward on Wednesday as two major political parties, struggling to bury years of hostility and avoid snap elections, agreed to re-install Giuseppe Conte as prime minister.

The anti-establishment 5-Star Movement and the opposition centre-left Democratic Party (PD) entered formal coalition talks after a ruling alliance between 5-Star and the right-wing League party collapsed this month after prolonged infighting.

The talks, which remain tense and could still break down, had been at risk of collapse over who should be named prime minister. But the PD confirmed on Wednesday that it had dropped its opposition to Conte, removing one big barrier to a deal.

The PD's leader also secured the backing of the party's executive on Wednesday to forge an alliance with 5-Star, despite a history of bitter relations between the two political rivals.

"We decided to agree to Conte as prime minister because that was what 5-Star wanted," PD boss Nicola Zingaretti said.

The prospect of a new government led by Conte, an academic who has no political affiliation but is considered close to the 5-Star, has buoyed markets, which are betting that Italy will avoid snap elections.

Italy's 10-year bond yield fell to a record low below 1%, two-year bond yields fell to their lowest since May 2018 at -0.22% and Italy's 50-year bond yield fell to a record low around 2.266%.

Investors fear early elections would be won by Matteo Salvini's hard-right League party, which could put Rome on a collision course with the European Union over expansionary government spending.

"DEPUTY PM MUST BE FROM PD"

5-Star and the PD have yet to agree on other top government posts or reveal a common policy platform, with only hours remaining before an effective Wednesday evening deadline for a deal.

President Sergio Mattarella has asked them to report back to him on progress later and if they fail to strike a deal, he is expected to name a caretaker government and call elections as early as October.

However, should Mattarella mandate Conte to form a cabinet, he will have a few more days to present a full list of ministers.

The incoming coalition might not agree the sort of formal coalition contract that 5-Star struck with its erstwhile partner the League, officials close to both parties said.

As negotiations went down to the wire, one of the posts still in play was that of deputy prime minister. The PD wants this job for one of its own, now that it has agreed to Conte staying on as prime minister.

"The problem is that if there is a premier from the 5-Star it is fair that his deputy is from the PD," PD deputy leader Andrea Orlando said on Twitter.

Conte, a virtually unknown lawyer when he was chosen by the League and 5-Star to lead their new government last year, was seen as a voice of reason within the outgoing coalition and has good relations with Mattarella.

Even in the event of a deal, another potentially major roadblock remains. The 5-Star announced in a blog post on Tuesday that any deal would need to be approved by an online vote of its members by next week.

Many of its rank and file are hostile to the PD and have used social media to urge Di Maio not to do a deal.

"Every party has its procedures. We hope it is going to be a great day," PD's Senate Andrea Marcucci told reporters before entering a meeting with his 5-Star counterpart in parliament.

(Additional reporting by Valentina Consiglio and Gavin Jones in Rome; Editing by Jon Boyle)

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