March 7, 2017 / 12:40 PM / 5 months ago

UPDATE 2-Investors switch to Italian linker as inflation hits target

* Italy sells bond linked to euro zone inflation

* Consumer price growth in bloc hit 2 percent in Feb

* German yields fall after weak economic data (Updates prices at close)

By John Geddie

LONDON, March 7 (Reuters) - Investors sold fixed-rate Italian government bonds on Tuesday in order to free up room in their portfolios for new inflation-linked debt that will offer protection against rising consumer prices in the euro zone.

The Italian government is poised to price a new 3 billion euro 10-year bond which has its interest payments linked to euro zone inflation, having collected more than 6 billion euros of orders, according to market news and data service IFR.

The sale comes after data showed inflation in the 19-member bloc rose to 2 percent for the first time in four years last month, roughly in line with the European Central Bank's medium-term target.

The yield on the equivalent Italian fixed-rate bond - which moves inversely to prices - rose to its highest level in around a week at 2.20 percent. That stretched the gap with benchmark German equivalents, which moved in the opposite direction following lacklustre economic data.

Bonds in Spain also underperformed, with yields climbing as much as 3 bps to a two-week high of 1.74 percent.

"The main reason for the move is supply," said Luca Cazzulani, a strategist for UniCredit in Milan.

"The timing is pretty smart because it comes right after the print of the preliminary inflation figure that just touched 2 percent. The money is there and it comes close to this data that will foster demand for inflation protection."

Austria sold 1.2 billion euros of bonds at auction and euro zone bailout fund ESM raised 3 billion euros via a sale of 10-year bonds.

Aside from the supply-related moves, some lacklustre economic data dragged down yields slightly in the bloc's core debt markets. Weak economic data supports the ultra-easy monetary policy of the ECB which has kept yields in check.

A sharp fall in domestic and euro zone demand drove the biggest monthly slump in German industrial orders in eight years in January, data showed.

The ECB meets on Thursday and is expected to resist calls from certain quarters to rein in its stimulus programme.

German 10-year bond yields fell 3 basis points to 0.32 percent, while two-year yields fell 6 bps to minus 0.88 percent, near a one-week low.

The gap between German 10- and two-year yields held at 118 basis points, within sight of its widest level since July 2014.

The bulk of that move has been driven by frenetic demand for shorter-dated German bonds, seen as one of the safest assets in the bloc amid tensions around France's upcoming elections.

ECB bond-buying has put these bonds in short supply, and analysts said there are signs that other central banks may also be purchasing them as a way of banking reserves used to keep their currency from appreciating too much.

As well as ECB bond-buying, data on Tuesday showed the Czech central bank bought a record 14.48 billion euros from the market in January, nearly as much as it acquired in all of last year.

For Reuters 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

Editing by Mark Trevelyan

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