October 7, 2016 / 7:41 AM / 10 months ago

Italy's bond yields set for biggest weekly rise since last December

* Moody's set to review Italy's ratings

* Italian yields set to end week with rise of almost 20 bps

* Worries about political risk weigh on Italian bonds

By Dhara Ranasinghe

LONDON, Oct 7 (Reuters) - Italian bond yields were poised on Friday to notch up their biggest weekly rise since December 2015, reflecting growing jitters over a looming referendum and ahead of a Moody's review of the country's sovereign rating later in the day.

Euro zone bond yields were broadly higher with sentiment fragile in a week that has seen sharp selling on talk of an eventual scaling back of massive ECB asset purchases, worries about a "hard Brexit" and strengthening U.S. data that could support the case for a December interest-rate hike.

For now, focus turned to Italy with Moody's ratings agency scheduled to release its review of the country's Baa2 rating later on Friday.

Commerzbank said the stable outlook on the rating could be at risk of a downgrade given rising political risks, still high debt levels and a weak banking sector.

"Moody's have not reviewed Italy since 2014 so it's time for an update on its views," said Commerzbank's interest rate strategist David Schnautz. "We have a very important referendum coming up, debt-to-GDP levels have not yet topped out and the banking sector is still weak."

Italy has taken measures to tackle bad loans but these efforts may not be sufficient to strengthen its ailing banking system, the International Monetary Fund said on Wednesday.

Italian bonds have underperformed euro zone peers in the months before a Dec. 4 referendum on constitutional reform on which Prime Minister Matteo Renzi had earlier staked his career.

Ten-year bond yields rose 2.5 basis points on Friday to 1.39 percent. It was on track to end the day with a weekly rise of almost 20 bps, which would mark the biggest weekly move since December last year.

Italy's successfully sold its first 50-year bond earlier this week and some analysts say the recent underperformance has gone too far.

BlackRock fund manager Jozef Prokes said on Thursday he had taken out his short position on Italian government bonds and was now more neutral on the market.

Like other peripheral countries, Italian bonds have been especially hard hit by a report this week that the European Central Bank might scale back its quantitative easing scheme.

While comments from ECB officials have helped soothe those concerns, markets remain on edge. In addition, a sharp sell-off in Britain's bond market and a rise in U.S. Treasury yields has tempered sentiment towards euro zone bonds.

Fears of a "hard exit" by Britain from the European Union - meaning it will give up trying to remain in the EU's single market in order to impose controls on immigration from the other 27 EU member states - have also surfaced this week, sending the British currency diving in Asian trade.

Attention also turned to a key U.S. non-farm payrolls report, due later in the day, for the latest update on the health of the jobs market.

Across the euro zone, bond yields were 2-3 basis points higher, with German Bund yields rising to 0.021 percent - their highest level in more than two weeks.

For Reuters new Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets (Reporting by Dhara Ranasinghe; Editing by Alison Williams)

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