* Focus on minority government’s ability to implement reforms
* Budget for 2017 and cutting the deficit the key challenges
* Gap between Spanish and Italian yields hits two-year high
* Spanish stocks, bond yields fall in line with rest of Europe (Adds Fitch comments, updates prices)
By Abhinav Ramnarayan
LONDON, Oct 31 (Reuters) - Spanish government bond yields fell on Monday after the country ended a 10-month political deadlock, but the fall was limited by lingering investor concerns over the country’s ability to implement reforms and rein in public spending.
Spain finally got a government for the first time this year after lawmakers agreed to grant conservative leader Mariano Rajoy a second term as prime minister on Saturday.
The benchmark Spanish 10-year bond saw its yield drop 5 basis points (bps) at one stage to 1.17 percent before rising again to 1.22 percent at 1500 GMT, down 1 bp on the day.
The fall in yields was shortlived partly because the market believes the minority government could find it challenging to get key reforms through.
“Now that they have a government the next question is how effective it will be. It is still a minority government - they will have difficulty pushing through budgets and reforms,” said Benjamin Schroeder, rates strategist at ING.
“The PSOE has abstained from voting against Rajoy but the question is how much they will support the government going forward,” he said.
PSOE, the opposition Socialist party, made it possible for Rajoy to win a parliamentary confidence vote after it lifted its veto on his second term and abstained.
The passing of the budget is key as Spain needs to tackle its excessive spending to meet European Union deficit limits.
Ratings agency Fitch said in a note that significant political risk remains in Spain.
“The PP minority government faces an inherent challenge in securing support for its policy agenda, including budget setting. This will be exacerbated by the Socialist Party’s calculations on supporting or opposing parts of the government’s agenda in response to the political challenge it faces from Podemos,” the Fitch analysts wrote.
The government has forecast that the deficit in 2017 will be 3.6 percent, well above the European Union deficit limits, so a new budget plan is needed to get the shortfall within the 3.1 percent target.
Rabobank strategists believe that if legislation proves hard to get through, Rajoy may call new elections to strengthen his hand, though he would need polls to shift more in his favour before doing so.
Though Spanish government bond yields were only marginally down on the day, the gap between Spanish and Italian yields hit 41.4 basis points, the highest level since the euro zone debt crisis in 2012.
The difference in borrowing costs between the two similarly-rated countries is often seen as a barometer of political risk, so is likely pointing towards a greater divergence in investor concern about the two countries, Schroeder said.
Spain’s IBEX share index was last down 0.6 percent, with shares in Bankia, BBVA and Banco Santander flat to 0.2 percent down on the day. (Additional reporting by Atul Prakash and Dhara Ranasinghe; editing by Mark Heinrich)