* Euro rises, Italian 10-year bond yields fall
* Yen and Swiss franc strengthen as risk aversion spreads
* Sterling up despite doubts over PM May's leadership
* Graphic: World FX rates in 2018 tmsnrt.rs/2egbfVh (Updates prices)
By Tom Finn
LONDON, Oct 23 (Reuters) - The euro rose on Tuesday before a meeting of the European Commission on Italy's budget that could see Brussels take the unprecedented step of rejecting it and demanding changes.
The dispute over Italy's spending plans and doubts about the leadership of Britain's prime minister who is mired in a stalemate over Brexit, means investors are focusing on the likelihood of further political turmoil in Europe.
Broad risk aversion pervaded currency markets on Tuesday, with the safe-haven Japanese yen and Swiss franc strengthening, while higher-yielding currencies like the Australian and New Zealand dollars fell.
Worries about Italy's spending has bred some doubt about the European Central Bank's plan to raise interest rates next summer and that has hurt the euro. But on Tuesday, it rose 0.2 percent to $1.1486.
Italy's bond yields fell on Tuesday before the European Commission's meeting. Mario Centeno, the head of the Eurogroup of eurozone finance ministers, said on Monday he was confident an agreement could be reached.
"The prospect of a normalisation of monetary policy was the main reason why the euro was able to appreciate over the past year. However, there is a rising risk that this support is now going to crumble," Commerzbank analyst Thu Lan Nguyen said.
Tensions are likely to rise further between Rome and Brussels, especially if the European Council launch an "Excessive Deficit Procedure" against Italy, said Philip Wee, currency strategist at DBS in a note.
"This would require Italy to provide a plan of corrective action to rein in its large public debt," Wee said.
The dollar index, a gauge of its value against six other major currencies, fell 0.2 percent after earlier reaching a two-month high of 96.158.
Turbulence in Europe has lifted the dollar recently along with expectations that a strong U.S. economy may see the Federal Reserve raise rates faster than assumed.
Britain's pound traded up 0.2 percent at $1.30 after falling on Monday on fears that the Irish border issue and disagreements within Britain's ruling Conservatives over Brexit could see Prime Minister Theresa May face a serious leadership challenge.
"Whispers of a growing number of Tory MP rebels losing their patience with May have put the risks of a lengthy UK political impasse and a Brexit policy mistake (exiting the EU without a deal) back on the table," said Viraj Patel, a currency strategist at ING.
"We think this noise is likely to keep the pound on the back foot this week," he said.
The dollar weakened half a percent against the Japanese yen to trade at 112.32 yen as risk-shy investors retreated from Asia's main share markets.
The Australian dollar lost 0.1 percent versus the U.S. dollar on Tuesday, changing hands at 0.7089. It lost 0.6 percent on Monday. (Editing by Larry King and Kirsten Donovan)