* Govt preparing to take stake in Monte dei Paschi -sources
* Italy passes 2017 budget, PM Renzi to resign at 1800 GMT
* Italian bond yields fall back near three-week lows
* Gap between Italy-Germany yields tightest in a month (Updates prices, adds budget, Renzi resignation timing)
By John Geddie
LONDON, Dec 7 (Reuters) - Italian sovereign bond yields fell to near three-week lows on Wednesday following reports that the government is preparing to rescue ailing lender Monte dei Paschi as hopes of a private recapitalisation fade.
Sources told Reuters Italy's government was preparing to take a 2 billion-euro controlling stake in the bank by buying junior bonds held by ordinary Italians.
The government is already the bank's single largest shareholder with a 4 percent share. Buying junior bonds, which would be converted into shares, would take that to 40 percent.
The newspaper La Stampa reported Italy was set to ask the ESM euro zone bailout fund for a 15 billion-euro loan for Monte dei Paschi and other struggling lenders An Italian Treasury spokesman denied the newspaper report.
Analysts said investor concerns that Italy could be headed for early elections next year, with Prime Minister Matteo Renzi set to resign after a referendum he championed failed on Sunday, were likely to keep the yield falls in check.
"Despite the fact that the probability of early elections has risen, the market is focusing on the banking sector and the fact the government seems to be showing more urgency in dealing with that problem," Mizuho strategist Antoine Bouvet said.
Ten-year government bond yields fell as low as 1.888 percent, matching a three-week low hit on Tuesday. It pulled back from those levels but remained 7.5 basis points (bps) lower on the day at 1.89 percent.
Yields on other low-rated peripheral bonds in Spain and Portugal fell sharply to three-week lows, while yields on German bonds -- the euro zone benchmark -- were slightly lower at 0.35 percent.
The gap between Italian and German bond yields stood at 155 basis points, the tightest in about a month, having climbed as high as 193 bps before Sunday's vote on constitutional reform.
An index of Italian bank shares rose over 4 percent to its highest level since June, and is headed for its best two-day run since the middle of 2012. Monte dei Paschi's stock rose around 11 percent on Wednesday.
The Italian parliament on Wednesday gave its final approval to the government's 2017 budget -- which has irked the European Union -- paving the way for Renzi's resignation, expected at 1800 GMT.
Renzi said he would quit his position after Sunday's referendum, but Italy's head of state had asked him to delay his resignation until after the budget was passed.
Hopes that the European Central Bank will deliver a fresh dose of monetary stimulus to the euro zone are also feeding investor demand for the bloc's debt, analysts said.
The ECB is expected on Thursday to change the terms of its asset-purchase programme to alleviate a shortage of bonds and to extend the programme beyond its current end date in March 2017.
At auctions on Wednesday, Germany sold 2.634 billion euros of two-year bonds. (Reporting by John Geddie; editing by Gareth Jones, Larry King)