June 14, 2017 / 2:23 PM / 2 months ago

RPT-GRAPHIC-Italian bonds motor as politics takes back seat

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* Italian/German yield gap 34 bps tighter in past week

* Sharpest narrowing in spread since mid-2013

* Easing concern about political risks boost sentiment

* Italy bond returns turn positive for first time in 2017

By Dhara Ranasinghe

LONDON, June 14 (Reuters) - Fading fears of early elections, a blow to populist parties in local polls and confidence that ECB stimulus will remain in place for some time have driven the most dramatic gains in Italian bonds in four years.

The premium investors demand for holding 10-year Italian government debt over top-rated German Bunds has narrowed 34 basis points in the past week to around 169 bps, reflecting a similar slide in Italian yields.

Just a week ago, the spread was above 200 bps -- its widest in seven weeks. The move has turned 2017 bond returns in the euro zone's third biggest economy positive for the first time.

The gap between Italian and German bond yields is seen as a gauge of investor concern over political and other risks in the euro zone. The focus of attention earlier this year was whether a rise in populism could see the bloc break up.

No coincidence then that the sharpest tightening in spreads since mid-2013 followed an easing of worries that Italy could face early elections and reduced euro zone break-up risks after the election of centrist Emmanuel Macron as French president.

A severe setback for Italy's eurosceptic 5-Star Movement in local elections at the weekend was the latest signal that the populist wave that worried investors looking ahead to 2017 was losing steam.

"The reality is that the market got itself positioned with a short view on Italy given the possibility of early elections in the third quarter," said Iain Stealey, who manages JPMorgan Asset Management's Global Bond Opportunities Fund.

"What you see now is a combination of that position unwinding and the realisation that if we don't get an election for a while, you get another 172 bps on top of German bonds and a yield of close to 2 percent."

Such steep falls in euro zone yields are rare - the last time was after Britain voted last June to leave the European Union. The uncertainty that followed was seen encouraging central banks to keep monetary policy loose, crushing yields.

The slide in Italian yields also follows signals from the European Central Bank that it is no rush to take away monetary stimulus that has helped weaker euro zone economies and signs of progress in fixing a frail banking sector.

Italy is close to agreeing with the European Commission a deal to rescue two ailing regional banks while limiting losses for investors, the country's economy minister said on Tuesday.

Graphics by Nigel Stephenson; editing by Alexander Smith

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