May 19, 2017 / 3:33 PM / 8 months ago

UPDATE 2-Peripheral bond yields fall as buoyant Europe contrasts with American woes

* Spanish, Italian govt bonds outperform higher-rated peers

* Draghi comments fuel optimism over euro zone economy

* Greek lawmakers pass austerity measures, pave way for aid

* Spanish socialist primary a cloud on political horizon

* Euro zone periphery govt bond yields (Updates closing prices)

By Abhinav Ramnarayan

LONDON, May 19 (Reuters) - Investors switched from high-rated euro zone government bonds to lower-rated Italian and Portuguese debt on Friday as a positive economic and political climate in Europe contrasted sharply with turmoil in the United States.

Earlier this week, euro zone bond yields dropped across the board, tracking a move in U.S. Treasury yields on concerns over U.S. President Donald Trump’s recent troubles and the implications for future policy in the world’s biggest economy.

But on Friday, investors started focusing on the positives in the euro zone, particularly after European Central Bank chief Mario Draghi’s optimistic comments the day before.

“Everything has turned upside down - European political risks have faded, the economy is looking strong while in the U.S. everybody is worried,” said DZ Bank strategist Daniel Lenz.

Trump struck a defiant tone on Thursday after days of political tumult, denying that he had asked former FBI Director James Comey to drop a probe into his former national security adviser and decrying a “witch hunt” against him.

The “transatlantic spread” between U.S. and German 10-year government bond yields has fallen to 187 basis points, well off its April peak of 216 bps.

This spread could narrow by another 30-40 basis points over the next two months, said Kevin O‘Nolan, a multi-asset portfolio manager at Fidelity.

“The Fed is on a pre-set path: the bigger potential surprise remains on the ECB side, and this week’s comments from policymakers have been balanced but leaning towards a faster path (of tightening),” he said, citing recent comments by ECB board member Benoit Coeure.

This narrowing of the spread is a change from earlier this year, when U.S. yields rose sharply on expectations that tax cuts and extraordinary spending measures from Trump would boost the economy.

In Europe at the time, the UK’s “Brexit” vote promoted concerns that an anti-establishment wave would affect key elections across the euro zone and threaten the bloc’s future.

So far that hasn’t happened, while as Draghi said on Thursday in Tel Aviv the euro area economic recovery is becoming increasingly broad based.

Euro zone growth has outstripped that of the U.S. so far this year, data earlier this month showed.

In a classic “risk-on” trade, Italian and Portuguese 10-year government bond yields dropped 3-4 basis points.

Portuguese yields briefly fell to seven-month lows and were set to end the week down 20 bps.

The German equivalent rose 2 bps on the day and other high-rated bond yields edged higher.

The Italy-German bond yield spread fell to an 11-day low at 175 bps, well off its 212 bps peak from earlier this year, while European stocks rallied and the euro hit a six-month high against the dollar.

In a further positive for the single currency bloc, Greek lawmakers approved pension cuts and tax hikes on Thursday sought by the country’s lenders to unlock vital financial aid.

Greece’s 10-year government bond yield fell 2 basis points to 5.77 percent, close to recent lows hit since an agreement on bailout reforms appeared to move closer.

A cloud on the euro zone political horizon, however, is Sunday’s Spanish socialist primary, the outcome of which could determine whether Prime Minister Mariano Rajoy will be able to see out his four-year term.

Spanish government bond yields appeared relatively unaffected by this vote, but that could change, said DZ Bank’s Lenz.

“Markets often can only focus at one thing at a time, but if (Pedro) Sanchez wins the vote, he could create problems for Rajoy and then we could see Spanish bonds affected,” he said.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=

Reporting by Abhinav Ramnarayan; Editing by Toby Davis and Ed Osmond

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