* Italian 10-year bond yields down 13 bps
* Set for biggest weekly fall since July
* Investors cover short positions before Italy referendum
* 'No' vote priced into markets (Writes through)
By John Geddie
LONDON, Dec 2 (Reuters) - Italy's borrowing costs took their biggest weekly fall since July as investors scrabbled on Friday to cover short positions before a crucial referendum this weekend that may deliver an unexpected or unclear outcome.
There have been signs this week that some investors have been hedging short positions in Italian debt, suggesting that even if they are right about a 'No' vote in Sunday's referendum the implications are far from clear cut.
"The market is reassured that there is going to be a soft 'No'...Where there is no radical change in government and no acceleration of the banking crisis," Societe Generale strategist Ciaran O'Hagan said.
"There has been very large shorting of Italy up until last week and what we have seen since is consistent with the idea that investors are taking off or covering those shorts."
Italy's 10-year bond yield - an indication of where it can borrow cash in bond markets - fell 13 basis points (bps) to 1.90 percent. It ended the week with a fall of almost 18 bps -- the biggest weekly drop in five months -- and was down about 25 bps from a 14-month high hit in November.
The gap to German bond yields - which shot to a 2 1/2-year high over 190 bps last week - fell to 163 bps on Friday.
Financial markets ended up on the wrong side of Britain's vote to leave the European Union in June and Donald Trump's victory in the U.S. presidential election last month.
They will be hoping the third time is lucky on Sunday, having sided with bookmakers and pollsters that expect Italian voters to reject a constitutional reform on which Prime Minister Matteo Renzi has staked his career.
But even if Renzi loses, fresh elections are not a given. President Sergio Mattarella could urge Renzi to stay, mandate another centre-leftist to form a new government or even try to persuade Silvio Berlusconi's centre-right party to join or support a caretaker or technocratic government.
"I suspect on Monday it will be very difficult to have a definitive opinion on what could be the future government in Italy and the appetite for further reform," said Franck Dixmier, global head of fixed income at AllianzGI, adding that the fund was "short" Italian bonds and had no exposure to Austria.
"The 'no' is clearly embedded in the current spread, but on top of the 'no' what will be important is the outlook provided in terms of the appetite for new general elections."
Analysts said firm demand at an Italian debt sale on Tuesday showed that some investors were scrambling to cover their short positions in futures markets, which are on a scale not seen since the 2011-2012 euro debt crisis. http://reut.rs/2fLW0lO
Shorting, or selling a borrowed asset, is a technique used to bet that the value of an asset will decline.
Euro zone bond yields were mostly lower, with Germany Bund yields down 5 bps at 0.28 percent, with some investors preferring safe-haven bonds in Germany and the United States ahead of the referendum.
In addition to the Italian vote, Austria on Sunday holds a presidential election that could make Norbert Hofer of the Freedom Party the first far-right head of state freely elected in western Europe since World War Two.
Austria's 10-year yield was down 6 bps at 0.53 percent , according to Tradeweb data. The gap between Austria's and Germany's yields dropped to 25 bps, having been at a near 10-month high of 33 bps last week.
French 10-year bond yields were down 8 bps at 0.72 percent and posted their biggest one-week fall in 11 weeks.
Data showing U.S. nonfarm payrolls rose 178,000 last month, broadly in line with market expectations, also helped support bond markets.
For Reuters new Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets
(Additional reporting by Dhara Ranasinghe; Editing by Ruth Pitchford)