Jan 31 (Reuters) - Italian government bonds outperformed their euro zone peers on Monday after parliament re-elected Sergio Mattarella as head of state, leaving former ECB chief Mario Draghi as prime minister, avoiding a sell-off seen across the rest of the market as traders ramped up their bets on ECB rate hikes.

Following the re-election on Saturday, Italy's 10-year yield briefly dropped to the lowest since Jan. 14 at 1.294% at the open and was last down 1 basis point at 1.34% by 1600 GMT.

That helped Italy avoid a sell-off that pushed German yields sharply higher, the closely watched risk premium it pays over German 10-year yields tightened by 5 bps to 133 bps, far below a 16-month high over 150 bps seen last week..

"The reaction shows the outcome is the one most favoured by markets. It's good news for BTPs, (market) is cognizant of the fact there could be a period of stability for the next six months or so allowing Draghi to get on with the reform package," said Gareth Hill, portfolio manager at Royal London Asset Management.

But Hill still used Monday's rally to move to a small underweight position, citing a lack of consensus across the government, evident in the struggle to agree on a president.

Analysts expect a further reduction in the Italian risk premium with Draghi remaining prime minister, expecting reform efforts to continue.

UniCredit expects it to fall to 120 bps, levels observed last November.

To take advantage of the positive momentum, Italy's Treasury could issue a new long-term syndicated bond this week.

In broader markets, investor focus was on inflation data and the European Central Bank's policy meeting on Thursday.

German annual inflation slowed in January but was above analyst expectations and remained above the ECB's 2% target, data showed on Monday.

Money markets ramped up their bets on a rate hike from the ECB, pricing in a 90% chance of a 10 basis-point rate hike by July, nearly 15 bps of rate hikes by September and over 25 bps of hikes by December, bets that are at odds with most forecasters' expectations and the bank's economic projections.

That was mirrored by a sharp sell-off across euro zone government bonds.

Germany's 10-year government bond yield, the euro zone benchmark, jumped to as high as 0.032%, returning to positive territory for the first time in 1-1/2 weeks and reaching its highest since May 2019. Bond yields move inversely with prices.

It was last up 4 bps at around 0%.

German 2-year and 5-year yields were up around 7 bps, setting respectively their highest since March 2019 and December 2018. Two-year yields were set for their biggest daily rise since March 2020.

"The focus is on the ECB this week, as it still has to clarify its posture towards inflation," Althea Spinozzi, fixed income strategist at Saxo Bank, said.

Elsewhere, the centre-left Socialists' victory in Portugal's parliamentary elections did not prevent Portuguese 10-year yields from rising to the highest since May 2020 at 0.689%, moving higher in line with the broader market.

(Reporting by Stefano Rebaudo; additional reporting by Sujata Rao and Yoruk Bahceli; Editing by Angus MacSwan and Bernadette Baum)