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* Risk of election upset prompts investors to take profits
* Debt demand reflects hunt for yield, short-term confidence shaky
* German state election suggests voters no longer scared of change
By Sinead Cruise
LONDON, Jan 24 (Reuters) - As Silvio Berlusconi's pre-election media blitz intensifies, so do fears of a costly detour from Italy's road back to economic strength.
Yields on short-term Italian debt, which have fallen sharply, are creeping up again, reflecting concerns that the billionaire tycoon, who lost power at the peak of Italy's fiscal woes in 2011, could have a big influence on the election outcome.
Some overseas investors are selling up now, rather than waiting to find out.
Luca Paolini, chief strategist at $135 billion investment house Pictet Asset Management, is telling clients to take their profits on Italian bonds ahead of a possible correction, not only in Italy but the broader euro zone.
"Risk assets have had a great rally on very optimistic assumptions on both politics and the economy. I suggest people take money out of all the peripheral countries until we see what happens in Italy, but maybe even until we see proof that the European Central Bank (ECB) is not falling asleep at the wheel."
"The U.S. is moving, Japan is moving, and the ECB is losing the currency war," said Paolini, who is now running a long position in gold as well as underweight positions in Italian bonds and equities.
While few are betting on a Berlusconi comeback, the former premier has steadily cut back a wide opinion poll lead held by the biggest centre-left group, the Democratic Party, thanks to a slew of television and radio appearances.
While the centre-left is still clear favourite to win the election and seize control of the lower house, Berlusconi is trying to prevent its control of the Senate, which would make it tougher for a new government to implement painful reforms and keep a coalition together.
The surprise defeat of German Chancellor Angela Merkel's Christian Democrats in Sunday's Lower Saxony state elections has provided a timely reminder of the unpredictability of politics.
And now that the possibility of a euro zone collapse seems to have receded after repeated reassurance of European Central Bank (ECB) support to members in difficulty, the continent's voters are taking other concerns to the ballot box and results are becoming tougher to call.
"I'm investing in the euro zone but not in Italy, because although they have a primary surplus, there's huge uncertainty politically," said Torgeir Hoien, head of fixed income at $19 billion Norwegian investment firm Skagen.
"What kind of policies will the Democratic Party pursue if they win? I am not certain. Berlusconi, I suspect, is much more popular in Italy than most of us appreciate. The common Italian was quite happy with him."
Such concerns have pushed the yield on two-year Italian bonds up 12 basis points (bps) to 1.52 percent since hitting a 33-month low on Jan. 16.
Similarly, the five-year yield has bounced 20 bps since Jan. 11 to 2.98 percent.
Mike Riddell, manager of the International Sovereign Bond Fund at M&G, the $351 billion investment arm of UK insurer Prudential, says the Italian election on Feb. 24-25 could stir up a new phase of political turmoil in Europe.
Last week he sold his 5-year and 7-year Italian government debt, bought at yields of 6-7 percent in July, banking a profit of more than 350 bps in the process. He is unwilling to gamble such gains on the hope of a seamless, market-friendly result.
Like the Spaniards, Irish and the Greeks, Italians are living in an age of austerity, paying a high price for the excessive spending of past governments.
Mario Monti, the technocrat parachuted in to succeed Berlusconi as premier in Italy's hour of need, has pushed through several unpopular fiscal reforms in an effort to bring the country's enormous debt under control.
He is now standing as a candidate against Berlusconi but so far has failed to boost his centrist alliance as much as he had hoped. Nevertheless, many analysts say the changing poll ratings could increase the chance that the centre-left is forced to make an alliance with Monti's group, keeping Berlusconi out.
There are fears that Italians, resentful of government mismanagement while they have kept their personal finances in order - boasting one of the lowest household debt-to-savings ratios in the EU - could be swayed by the lure of a more relaxed regime offering tax cuts.
Berlusconi has increased his popularity by promising an immediate repeal of a hated housing tax imposed by Monti.
Market conditions have clearly improved under Monti. Italy managed to sell 6 billion euros of 15-year bonds at a 4.8 percent yield earlier this month, its first such offering in more than two years.
Foreign buyers bought 60 percent of the issue, the head of the Treasury Debt Management office told Reuters.
But some commentators argue that robust recent demand for Italian bonds is down to an increasingly desperate search for longer-term income among investors, who remain on high alert for downside in the event of an upset.
Italy pays almost five times the rate Germany pays its five-year bondholders, so any signs of resistance towards austerity could spell future funding trouble for a country that has a refinancing target of 420 billion euros in 2013.
"We've seen fledgling recoveries snuffed out in their early stages on a few occasions since the debt crisis started, and it wouldn't be a surprise if another political accident tramples green shoots once again," said Ben Bennett, credit strategist at Legal & General Investment Management.