EURO GOVT-Italy yields fall on slightly upbeat PMI data

* Italian services sector contraction slows

* Relief rally in Italy, Spain bonds seen shortlived

* Reaction to U.S. election seen muted

LONDON, Nov 6 (Reuters) - Italian bond yields fell on Tuesday after a survey showed a slowdown in the contraction in the country's services sector during October, providing a sliver of hope for the recession-mired economy.

The Markit/ADACI Business Activity index rose for the third month running to 46.0 the highest since Aug. 2011, from 44.5 the previous month. Although this was still below the 50.0 mark that separates contraction from growth, it could signal that the worst phase of the retreat may be over, prompting a relief rally in Italian bond prices.

Traders and analysts, however, saw little scope for further gains on uncertainty over the outcome of U.S. elections and when Spain will request aid that could trigger ECB bond purchases.

``The Italian PMI was better than expected, unlike the French and the German numbers so that was a small positive for Italian bonds and people are probably closing short positions after yesterday's widening,'' a trader said.

Italian 10-year yields were last down 10 basis points at 4.90 percent with two-year yields 11 bps lower at 2.34 percent.


Spanish yields also fell after rising since Friday when Madrid surprised markets by announcing the launch of a new five-year benchmark bond this week, as well as a tap of a 2032 bond -- its first attempt to sell debt with a maturity of more than 10 years since July 2011. Dealers typically try and cheapen the paper - or build a concession - before sales.

Spanish 10-year bond yields were 10 basis points lower on the day at 5.68 percent with Rabobank noting they were at a ``technically interesting juncture'', having broken above a downward trend channel and now testing resistance from a longer-term trend line which began in March.

Tuesday's fall in yields was, however, unlikely to be sustained with the European Commission expected to set dire economic forecasts for Spain, which is now at the forefront of the euro zone debt crisis.

Investors are also uncertain about when Spain will decide on an aid request which could trigger European Central Bank buying of its bonds to lower its borrowing costs.

Some market participants say Prime Minister Mariano Rajoy was likely waiting for elections in the economically important but restive Catalonia region on Nov. 22 before deciding whether or not to request euro zone aid.

``We see (Spanish bonds) trading sideways and no big change in sentiment as people are waiting for Spain to ask for external aid,'' said Norbert Wuthe, a rate strategist at Bayerische Landesbank.

``Our position is Spain will wait for the elections in Catalonia... Rajoy doesn't want to risk suffering a major loss at these regional elections so he's avoiding asking for help but we expect him to make a move the last week of November/first week of December.''

Low-risk German government bonds were steady, with investors wary of placing big bets before Tuesday's close-run U.S. election and a Greek parliamentary vote on crucial austerity measures.

Polls indicate the race between President Barack Obama and Republican challenger Mitt Romney will be very close with the risk of a change in fiscal and monetary policy in the world's largest economy keeping investors on the sidelines .

Bunds are likely to be buffeted by any moves in U.S. Treasuries following the election, although concerns related to the euro zone debt crisis will remain the main driver of the market.

Some analysts say a win by Obama would be positive for U.S. government debt, with U.S. Federal Reserve Chairman Ben Bernanke perhaps staying on beyond January 2014 when his term expires, while a Romney win could be positive for stocks, helped by business-friendly policies and tax cuts.

``The worse case would be an uncertain outcome over who the next president will be... that would be positive for the likes of Bunds,'' said Gary Jenkins, director of Swordfish Research.

December Bund futures were four ticks down on the day to settle at 142.09 with German 10-year yields up 2 bps at 1.45 percent.