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UPDATE 3-Italian yields drop as PM looks to form new government

* Conte resigns in bid to form new government

* Italian yields drop 3-5 bps across the curve

* German yields drop to 2-week low in early trade

* Hurdles to U.S. stimulus plan worry stock markets (Updates prices, adds EU bond update)

LONDON, Jan 26 (Reuters) - Italian government bond yields dropped across the curve on Tuesday as Prime Minister Giuseppe Conte prepared to try to form a new government, raising hopes for a return of some political stability.

Conte handed in his resignation to the head of state on Tuesday, hoping he would be given an opportunity to put together a new coalition and rebuild his parliamentary majority.

“If Conte does manage to form a new government within a week with a stable majority, then the potential spread-tightening is significant,” said ING rates strategist Antoine Bouvet. “But it is still (a) political gamble at this point.”

Italian government bond yields dropped 3-5 basis points across the curve, with the benchmark 10-year yield falling 3.7 bps to 0.611%.

The closely watched Italy-Germany bond yield spread tightened by five basis points on the day to 113.8 bps.

While Conte’s resignation might allow an election to be avoided in Italy, the combination of political and stock market jitters over U.S. fiscal stimulus bolstered demand for safe havens such as German Bunds.

Asian stocks declined on Tuesday, retreating from record highs as lingering concerns about potential roadblocks to U.S. President Joe Biden administration’s $1.9 trillion stimulus weighed on sentiment.

Germany’s 10-year government bond yield dropped to a two-week low in early trade on Tuesday, though it was back up by 2 bps to -0.53% by the session close.

U.S. 10-year Treasury yields dropped to a three-week low of 1.028% earlier in the session as the U.S. Senate pushed to pass its COVID-19 bill.

The European Union was set to complete a 14-billion-euro syndicated bond sale comprising a new seven-year benchmark bond issue and a tap of its outstanding 2050 debt, International Financing Review reported. (Reporting by Abhinav Ramnarayan, editing by Karin Strohecker and Mark Heinrich)

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