* Italian bond yields fall after Friday sell-off * Focus on chance of a new government * EU hires banks for first SURE bond sale of the year (Updates prices, adds ECB economist, bond buying data) LONDON, Jan 25 (Reuters) - Italy’s borrowing costs fell from two-and-a-half-month highs on Monday as investors focused on the chance that snap elections may be averted by the formation of a new government. Italian Prime Minister Giuseppe Conte could resign as early as Tuesday and then form a fresh coalition that would draw on centrist and “responsible” members of parliament, according to La Repubblica. Rome’s bonds were rallying after coming under pressure on Friday, when ruling parties flagged snap elections as the only way out of a political impasse. At 1536 GMT, Italy’s 10-year bond yield was down 8 basis points to 0.64%, erasing much of Friday’s sell-off, after touching two-and-a-half-month highs earlier. The gap between Italy and Germany’s 10-year yields - effectively the risk premium on Italian debt - was at 118 basis points, dipping from its highest since November above 120 basis points on Friday. “Italian bonds are taking well the news of a possible Conte resignation before the Senate vote later this week,” said Antoine Bouvet, senior rates strategist at ING. Italian bonds continued their rally despite Reuters citing a government source suggesting that Conte was not in fact planning on resigning with a view to forming a new government. “My impression is that the market attributes a good chance of the prime minister’s gambit (resigning now to gain a new mandate to form a new government) succeeding,” Bouvet said. Elsewhere, German business morale worsened more than expected in January as a second wave of COVID-19 brought a recovery in Europe’s largest economy to a halt, the Ifo institute business climate index showed. Broader euro zone bond yields also fell, with Germany’s 10-year bond yield, the benchmark for the bloc, down 3 basis points to -0.54%.. In the primary market, the European Union hired banks for its first bond sale of the year, to sell a new seven-year bond and reopen the 30-year bond it issued last November to back its SURE unemployment scheme, according to a lead manager memo seen by Reuters. Reuters first reported last week that the EU was discussing these maturities with investors. The deal will be “launched in the near future, subject to market conditions”, a phrase debt management offices usually use a day before a sale. The European Central Bank said it bought a net 16.823 billion euros ($13.86 billion) of assets last week as part of its quantitative easing programme, below the 25.958 billion euros it purchased a week earlier. ECB chief economist Philip Lane said separately on Monday that the central bank mainly focuses on bank credit conditions and bond markets when assessing if financing conditions are favourable. This came after ECB President Christine Lagarde renewed a commitment to maintaining “favourable” financing conditions last week, though did not say what measures were being looked at. Euro zone bond yields rose last Thursday, when the ECB was perceived in its policy decision as emphasizing that it may not use the firepower of its pandemic bond purchases in full. (Reporting by Yoruk Bahceli and Dhara Ranasinghe, additional reporting by Julien Ponthus; editing by Hugh Lawson and Mark Heinrich)