November 22, 2018 / 12:04 PM / a year ago

UPDATE 3-Italy's bond yields dive for second day on budget deal hopes

* Italy’s bond yields down as much as 21 bps

* Positive headlines, short-covering, TLTRO talk drive fall

* Progress on Brexit adds to upbeat move in risk assets (Updates prices)

By Dhara Ranasinghe

LONDON, Nov 22 (Reuters) - Italy’s two-year bond yield fell to its lowest since late September on Thursday on the prospect of a compromise between Rome and EU authorities over its contentious budget plans.

Traders said that a covering of short positions - or bets on further weakness - in Italian bonds and talk of a new round of cheap ECB multi-year loans to banks, seen as particularly beneficial to Italy, helped drive the yield slide.

Added to that was the news of a draft declaration between the EU and Britain on future ties, which eased the possibility of a hard Brexit and boosted investor appetite for risk.

Italy’s two-year bond yield fell as much as 21 basis points to a low of 0.92 percent at one stage, though it did ease to one percent by the market close. Still, a 12 basis point fall adds to a 26 bps fall on Wednesday that was the biggest daily slide since June.

Five-year yields tumbled 14 bps to 2.52 percent, while 10-year yields fell 5 bps to 3.35 percent — pushing the gap over German Bund yields to 306.5 bps from 317 bps earlier in the session.

Positive noises from officials lifted sentiment a day after the European Commission took the first step towards disciplining the country over its budget after Rome refused to change it.

Pierre Moscovici, the European Union commissioner for economic affairs, said on Thursday he was confident talks with Italy would yield a compromise. Italian Prime Minister Giuseppe Conte meanwhile called for a toning down of rhetoric in a bid to calm markets as leaders of Rome’s populist government said they would press ahead with the budget plans.

“You could say there are two factors going on here - talk in recent days, all denied, about the government making some sort of compromise on the budget talks and positioning,” said Luca Cazzulani, a fixed income strategist at UniCredit in Milan.

“I think these rumours have encouraged some investors to cover their short positions.”

Analysts said that with the EU’s decision to press ahead with disciplinary action now formal, there was some breathing space for Italian bonds.

“A lot of investors thought the European Commission would take faster action and underestimated how slow the process would be,” said BBVA strategist Jaime Costero Denche.

“We are now seeing some repricing, as they understand the complicated negotiation process that is coming up and that you are not going to have sanctions on Italy in the next two months.”

Traders in Italy added that talk of a new round of cheap ECB loans to banks — known as TLTROs — also pushed down yields.

There appeared to be no immediate trigger for that talk. Minutes from the ECB’s October meeting released on Thursday said that a remark was made that the maturity of TLTROs falling below one year could impact banks’ liquidity position.

For now, the market shrugged off signs of weak demand from institutional investors for the latest ‘BTP Italia’ inflation-linked retail bond. The bond was offered to retail investors in the past three days raising 863.3 million euros, one of the lowest take-ups since this class of bonds was launched in 2012.

Elsewhere, a rise in UK gilt yields on the latest Brexit headlines put some upward pressure on German Bund yields. Overall trade was subdued due to the U.S. Thanksgiving holiday.

Reporting by Dhara Ranasinghe, Additional reporting by Valentina Za in MILAN and Abhinav Ramnarayan in LONDON; Editing by John Stonestreet, William Maclean

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