(Recasts lead, adds investors quotes)
By Dhara Ranasinghe and Sujata Rao
LONDON/MILAN Aug 20 (Reuters) - Italy's bond yields tumbled on Tuesday amid growing investor expectations that its political crisis could be short-lived, potentially paving the way for a new coalition government and reducing the uncertainty of snap elections.
Prime Minister Giuseppe Conte announced his resignation as he made a blistering attack on his interior minister, Matteo Salvini, accusing him of sinking the ruling coalition for personal and political gain.
Salvini has demanded early elections, 3-1/2 years ahead of schedule, confident his surging popularity in the polls will sweep him into power as prime minister and push the anti-establishment 5-Star into opposition.
But several investors told Reuters there was no panic in the markets as the Milan bourse only lost 1.11 percent while bond yield premia over safe-haven benchmark Germany narrowed.
Italy's 10-year bond yield tumbled 11 bps to 1.32% , narrowing the gap over benchmark German Bund yields to just over 200 bps - its tightest in around 1-1/2 weeks.
"The way the market is reacting today suggests market participants believe a 2019 election is unlikely," said Bluebay Asset Management chief investment officer Mark Dowding.
"We are constructive on BTPs and that's more on a valuation basis – in a world of negative rates you pay to look through the volatility and the noise of Italian politics," Dowding added.
"BTP Futures saw a lot of buys today as investors read things positively," said Carlo Franchini, head of institutional clients at Banca Ifigest.
Conte, who belongs to neither of the coalition's two parties, was to hand in his resignation later on Tuesday, allowing the head of state to start formal consultations with parties to see if a new coalition can be formed.
"Conte was quite strong in addressing the point that going to the polls soon would not be in the interest of the country," said Luca Cazzulani, rates strategist at UniCredit.
"It's still premature to assess the direction for yields but the less likely snap elections become, the stronger the correlation between BTPs and other markets."
He said expectations for European Central Bank stimulus soon also supported Italian bonds.
In late trade, Italian bond yields were down 4-10 basis points on the day across the curve.
Italy's 5-year credit default swaps, instruments used to insure exposure to the credit, slipped to 202 basis points, having opened at 205 bps earlier, according to IHS Markit.
The Italian banking stock sub-index briefly slipped more than 2% during Conte's speech, but recovered sharply after news of his resignation. It closed down 1.3%.
Markets may not cheer the prospect of new elections but they were frequently unnerved by the frequent squabbles within the Italian coalition.
"As far as the process is concerned that means Conte resigns as prime minister of this government but that doesn't mean that if there was an agreement between opposition parties he couldn't be reinstated as PM," said Rabobank rates strategist Matt Cairns.
He added that momentum appeared to be behind a formation of a caretaker government rather than general elections.
Outside Italy, most 10-year bond yields were 3-5 bps lower on the day as risk-off sentiment in world markets and renewed concerns about Brexit boosted demand for safe havens.
Germany's 10-year bond yield was down 4 bps at -0.69% . (Additional reporting by Abhinav Ramnarayan, Stephen Jewkes and Pamela Barbaglia Editing by Mark Heinrich)