June 13, 2018 / 10:58 AM / a month ago

CORRECTED-UPDATE 2-Italian bonds in demand as Savona calls euro "indispensable"

(Corrects timing of peak in Italian 2-year bond yield in paragraph 9 to two-weeks ago from 1-week ago.)

* EU Affairs Minister Savona says fully backs euro

* Italian borrowing costs drop, auction goes smoothly

* Key central bank meetings loom in U.S. and euro zone

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr

By Abhinav Ramnarayan

LONDON, June 13 (Reuters) - Italy’s borrowing costs dropped sharply on Wednesday after the country’s new EU Affairs Minister Paolo Savona said the euro was “indispensable”, helping bolster demand at an auction of Italian government bonds.

The country sold 5.63 billion euros of bonds in the auction on Wednesday, though the borrowing costs were still the highest since before the ECB began its 2.55 trillion euro bond-buying scheme.

Savona has previously expressed hostile views on the euro, and the 81-year-old’s potential appointment as economy minister for the anti-establishment coalition last month had sparked a market selloff. His appointment to that role was later vetoed.

But in a meeting with foreign press on Tuesday, Savona was at pains to stress he fully backed the euro and did not want to prepare for Italy to quit the single currency.

The comments soothed worries about the euro membership of the bloc’s third largest economy under the stewardship of the 5-Star Movement/League coalition.

“It wouldn’t be surprise for other people in the government to make these comments, but from him it’s significant and quite as random as Trump in his public statements,” said Commerzbank strategist Christoph Rieger.

“Perhaps they are recognising that they can get more out of the EU if they at least commit to certain key principles.”

Italy’s two-year government bond, the asset through which market fears about Italian redenomination and default have largely played out, saw its yield drop well below 1 percent and was last down 17 basis points at 0.87 percent.

This is below where it started the week — at 1.13 percent — and a far cry from a peak two weeks ago of 2.73 percent when the market concerns were at their most intense.

The yield on the benchmark 10-year government bond was 9 bps lower at 2.78 percent, while the closely-watched spread over German yields was at 229 basis points, well below the 268 bps level at the start of the week.

Rieger of Commerbank warned that words alone would not be enough to keep Italian borrowing costs pinned lower in the long term, particularly given the high-spending plans of this coalition government.

“In the longer term they need to do something different to bring the deficit under control, not just pay lip service towards the euro,” he said.

Other euro zone bond yields were flat to 3 basis points lower as data showed euro zone industrial production fell in April.

But investors are largely hesitating to take any strong views ahead of two key central bank meetings. The U.S. Federal Reserve ends its policy meeting today and the European Central Bank is due to meet on Thursday.

“The Fed meeting tonight is a big factor and Treasury yields could have an overriding impact on European bond markets from tomorrow,” said ING strategist Martin van Vliet.

The yield on Germany’s 10-year government bond, the benchmark for the region, was flat at 0.49 percent though some others, such as the French equivalent, was as much as 3 bps lower.

Reporting by Abhinav Ramnarayan; Editing by Toby Chopra

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