* German CPI data due at 1200 GMT
* Italian bonds knocked by early election fears
* Italy to auction debt in test of investor demand
By John Geddie
LONDON, May 30 (Reuters) - German government bond yields fell to their lowest level in more than a month on Tuesday ahead of inflation data from the bloc’s biggest economy expected to underscore the challenges the European Central Bank faces in normalising monetary policy.
A weak first reading of German data for May, as expected by many analysts and economists, would further temper expectations for policy tweaks at the central bank’s June 8 meeting following cautious comments from ECB chief Mario Draghi on Monday.
While some policymakers are calling for an end to aggressive bond purchases and sub-zero rates as growth recovers, Draghi told the European Parliament that inflation remains subdued and the bloc still requires substantial stimulus.
Spanish inflation rose 2 percent year-on-year in May, in line with a Reuters forecast but down from a previous reading of 2.6 percent. German data is due at 1200GMT.
“The Spanish and German flash CPIs will underscore that euro area inflation is in for a major drop as the support from energy base and calendar effects evaporates,” Commerzbank analyst Michael Leister said.
“This will ... underscore the ‘firm conviction’ that extraordinary stimulus is still needed.”
Economists polled by Reuters expect German inflation at 1.6 percent year-on-year in May, down from 2 percent in the previous month. Commerzbank expects an even lower reading of 1.5 percent.
The bloc’s benchmark German 10-year yield fell to 0.29 percent in early trading on Tuesday, the lowest since April 25.
But it was not only doubts about inflation keeping up demand for the safe haven debt, as the potential for early elections in Italy knocked lower-rated bonds in southern Europe.
Italian 10-year yields climbed as much as 4 basis points to a near two-week high of 2.21 percent, dragging up yields in neighbouring Spain by a similar amount.
Prime Minister Matteo Renzi said on Sunday that it makes sense “from a European perspective” for Italy’s next election to be held at the same time as Germany‘s, scheduled for September.
Investors have been worried about the rise of the anti-euro 5-Star Movement, which has led some polls recently, and what it might mean for Italy’s future in the single currency bloc. Polls at the moment point towards a hung parliament.
Italy is due to offer up to 7.5 billion euros over three bonds at an auction on Tuesday in a test of investor demand.
Concerns are also growing around Greece after a German press report saying Athens may opt out of its next bailout payment if creditors cannot strike a debt relief deal.
This could leave Greece without the cash to pay debts falling due in July, opening up the possibility of default.
Greece’s finance minister said on Monday that creditors need to reach a deal on debt relief measures at the next meeting of euro zone finance ministers in June.
Greek yields were little changed in early trading on Tuesday.
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Editing by Andrew Heavens