Tension over Trump short-lived in euro zone bond market, Italy up next

* Biggest daily swings since Britain's Brexit vote

* Italy underperforms, weighed down by upcoming referendum

* U.S. yields reverse falls to hit multi-month highs

* Analysts say Trump may embark on spending spree

* Many expect Fed rate hike to go ahead (Recasts, adds quotes, updates prices, Fed hike expectations)

By Dhara Ranasinghe and John Geddie

LONDON, Nov 9 (Reuters) - Euro zone government bond yields lifted off initial lows on Wednesday after Donald Trump's shock victory in the U.S. presidential election, though the result threw a spotlight on Italy's upcoming referendum.

Italian government bonds were notable underperformers, with 10-year yields rising 7 basis points at one stage to 1.71 percent, on a day when the best-rated euro zone government bond yields looked set to end the day either unchanged or slightly lower.

"There is no direct connection between Trump's election and the Italian referendum but whenever there is political noise, people are reminded of Italy and the political situation there," said BBVA (LSE: 931474.L - news) strategist Jaime Costero Denche.

Franklin Templeton's David Zahn told Reuters on Wednesday that Trump's win suggests a stronger-than-expected chance of a "No" vote in the Dec (Shanghai: 600875.SS - news) . 4 referendum, on which Prime Minister Matteo Renzi has staked his political future.

Prediction aggregator Hypermind now has set the chance of a "No" vote in the referendum at 65 percent.

A loss for Renzi would at the very least undermine his position and make it difficult to implement reforms needed to increase economic growth and improve the efficiency of the tax system, BBVA's Denche said.

The market's tendency to use Italian government bond (BTP) futures as a hedging tool may also have contributed to the underperformance, he added.

Earlier on Wednesday, benchmark German 10-year Bund yields fell to two-week lows on worries about what a Trump presidency might mean for U.S. economic policy, geopolitics, free trade and immigration.

But that move reversed after Trump struck a conciliatory tone in his victory speech, in which he also talked about rebuilding infrastructure and a project of national growth that analysts said could lead to more borrowing in bond markets.

As long-dated U.S. Treasury yields surged to multi-month highs, German 10-year government bonds nudged briefly into positive territory before easing to 0.16 percent, down just 1.7 bps on the day.

"We've seen quite a big rise in U.S. Treasuries. It's trading on the back of some quite pragmatic comments from Trump," said Rabobank strategist Lyn Graham-Taylor.

"His speech had a fiscal impulse to it, so the hope is he won't go too strongly on protectionism and it will overall be positive for growth."

Ten-year U.S. yields initially fell to 1.72 percent before sharply rebounding to hit 1.97 percent, the highest level since March 16. Thirty-year yields climbed more than 15 bps to hit 2.81 percent, their highest since Jan. 28.

The breakeven rates on Treasury Inflation Protected Securities and inflation derivatives, which measure investors' inflation expectations, jumped to levels not seen since July 2015, according to Reuters data.

"The initial reaction in markets was violent, but gradually we have seen that risk-off move retrace quite significantly," said Roger Douglas, a senior portfolio manager at Deutsche Asset Management.

"It could be people looking for signs of moderation in his policy, or people starting to wonder whether that moderation will start to come through in the near future."

FED HIKE STILL ON

Trump's election win briefly cast doubt on whether the U.S. Federal Reserve will raise interest rates in December, but by the end of the day most appeared to snap back to their earlier stance.

CME's Fedwatch tool recorded a drop in expectations of a December hike to around 60 percent in the early hours of U.S. trading, but by 1600 GMT it was back up above 70 percent.

The 70 percent figure is seen as key because a majority of U.S. rate hikes have taken place when expectations were at that level or above, a recent Goldman Sachs (NYSE: GS-PB - news) study showed.

Frederik Ducrozet, a senior economist at Pictet Wealth Management, said the U.S. election result meant any prospect of a tapering of European Central Bank monetary stimulus looked even less likely than before.

Euro zone bond markets have been rattled in recent weeks by talk of a possible scaling-back of ECB bond-buying although many economists expect the ECB to extend its asset purchase scheme when it next meets in December.

Euribor futures rose 1-2 bps across the 2017-2020 strip as investors started to price in a small chance of an ECB interest rate cut in coming years. (Additional reporting by Abhinav Ramnarayan; Editing by Mark Heinrich)