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LONDON, Dec 21 (Reuters) - Spanish government bond yields hit five-week lows on Wednesday as investors shifted money out of similiarly rated Italian debt where bank bailouts and political uncertainty have made what ING strategists called a "dangerous cocktail".
The gap between yields on Spanish and Italian 10-year debt nudged back above 50 basis points (bps), a level last breached in the days after a failed constitutional reform vote triggered the resignation of Italian prime minister Matteo Renzi.
While Renzi plots his path back to power, possibly in an election that could come as early as next year, his successor Paolo Gentiloni is trying to get a grip on the ailing banking sector.
The most immediate concern is Italy's third-largest lender Monte dei Paschi which seems destined for state aid as a private recapitalisation flags. The government is expected to seek parliamentary approval for 20 billion euros of extra borrowing powers on Wednesday.
Strategists at ING said the combination of possible snap elections next year and higher bond issuance to prop up Italy's ailing banks "arguably make for a dangerous cocktail" for Italian bonds in 2017.
A trend that should only help neighbouring Spain where a fragile minority government has managed to keep recovery from a deep recession on track.
"Given that Italy's banking sector is in the headlines at the moment, investors would appear to be giving preference in the periphery segment to the Iberian peninsula," DZ Bank strategist Sebastian Fellechner said.
Spain's 10-year bond yields fell as much as 3 bps on Wednesday to hit 1.31 percent, the lowest since Nov. 10.
Most other euro zone yields were also lower on the day, including Italy's.
But the premium Italy pays to borrow over Spain and benchmark euro zone borrower Germany has risen over 10 bps over the past week.
Shares in Monte dei Paschi plunged 8 percent on Wednesday after a document on its website showed Italy's third largest lender could run out of liquidity after four months.
Monte dei Paschi has raised about 500 million euros as of Tuesday in a voluntary debt-to-equity offer that is a key part of a last-ditch attempt to raise 5 billion and avert state intervention, a source close to the matter said.
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 (Editing by Louise Ireland)