* No shorts of above 0.5% in Intesa, UniCredit -Consob data
* Italy bank stocks outperformed euro peers for most of 2019
* Politics, economy may put Italy bank recovery at risk
* FACTBOX on funds short positions: click on
By Danilo Masoni
MILAN, May 23 (Reuters) - Funds that built big short positions in Italy's leading banks from early 2018 have lowered the size of their bets in the last few months as political worries eased, regulatory data shows.
Despite a looming budget showdown between Rome and Brussels, a Reuters analysis of data from Italian market regulator Consob shows that as of May 21 there were no net short positions above 0.5% in shares of Italy's two largest banks.
Consob discloses changes in short positions above 0.5% and in 2018 funds had short positions in Intesa Sanpaolo and UniCredit which were above this level.
Disclosed shorts in Banco BPM, Italy's third largest bank and the most shorted by several funds, have fallen from their 2018 peaks, while shorts in UBI Banca and BPER are more mixed, although the Consob data shows some funds have eased pressure on them too.
Short selling is a mainstay of hedge fund investing and is driven by expectations that a share price will fall, which means they can be bought back later at a lower price. Bank stocks are often used as a "proxy" for a country's economic fortunes and in the case of Italian lenders as a substitute for the eurozone.
The timing and size of the reduction in the size of short positions varied but while Intesa and UniCredit were off Consob's disclosure radar by mid-2018, signs of an easing off in short-selling of smaller banks emerged around the end of 2018.
Reductions continued into this year as an immediate budget crisis in the euro zone's third-largest economy was averted in December and reflect a broader market recovery, as well as the banks' progress in cutting their backlog of bad loans.
Among the big names that have cut their short positions are Bridgewater and BlackRock, the world's biggest fund manager.
Bridgewater, which last year built a $22 billion short bet against Europe, cut its shorts in Intesa, UniCredit and BPM to below 0.5% in July 2018. The U.S. firm has no short above 0.5% in Italian banks, the Consob data shows. reut.rs/2EvzMTm
Bridgewater did not respond to a request for comment and BlackRock declined to comment.
With the temperature of Italian politics heating up again amid European Union elections, lingering worries that Italy faces another showdown with Brussels and the risk of a rating downgrade, bank stocks are unlikely to be out of the woods.
Italian Deputy Prime Minister Matteo Salvini rattled bond investors this month when he said Rome should be willing to break the EU's deficit ceiling of 3% of gross domestic product and push debt to 140% of GDP if necessary to cut unemployment.
"Pressure on banks has eased somewhat, but Italy has a political problem," said Carlo Franchini, head of institutional clients at Banca Ifigest in Milan.
European Central Bank measures to alleviate pressure on margins provided some support to Italian banking stocks, while the latest earnings reports also provided some relief, but the interest rate outlook in Europe could further hurt profits.
"Despite a heavy downward shift of the yield curve and yet another postponement in the expectation of rate normalisation, Italian banks have held up quite nicely," Andrea Filtri, co-head of research at Mediobanca Securities in London, said.
Italian bank shares, which are also particularly sensitive to political risk given their significant holdings of government debt, had until last week outperformed eurozone peers for most of 2019.
But political risk is once again raising its head.
"Reasons to go short on Italy will persist while this government stays in power. (The) key will be what happens to it after the EU elections," Franchini said.
Reporting by Danilo Masoni, editing by Josephine Mason and Alexander Smith