* Key election looms this weekend
* Italy to sell up to 7.75 bln euros of bonds
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr
By Abhinav Ramnarayan
LONDON, Feb 27 (Reuters) - Italian government debt outperformed its euro zone peers on Tuesday ahead of a large bond auction that is likely to test market sentiment as the country gears up for a national election whose outcome is uncertain.
The gap between Italian and German bond yields has widened in recent weeks as the vote has got nearer, making Italian bonds more attractive to those investors who take a more sanguine view of political risk in the euro zone’s third largest economy.
As a result, the yield on 10-year Italian government bonds dropped further on Tuesday, having been the best performing euro zone government debt on Monday.
“The market is looking beyond the election and seeing that most of the tail risks should be averted,” said Commerzbank strategist Christoph Rieger.
Polls point to a hung parliament in Italy. But while they suggest the anti-establishment 5-Star Movement is by far the most popular party, a centre-right coalition led by Forza Italia and the League party looks the most likely outcome.
The yield on Italy’s 10-year government bonds was 1.5 basis points lower at 2.09 percent, and the gap over Germany narrowed to 143 basis points, well off recent highs of 152 bps. ,
Rieger said there were also technical reasons for the outperformance: over 9 billion euros of coupon repayments are due at the end of this week, primarily from Italian debt. For this reason, he expected the Italian debt auction to go well.
Italy is set to sell up to 7.75 billion euros of debt on Thursday in an auction, including 10-year bonds.
Better-rated euro zone government bonds edged higher on Tuesday before the release of German consumer price data, with the yield on benchmark German 10-year bonds rising one basis point to 0.66 percent.
Market expectations are for HICP inflation to come in at 1.3 percent, comfortably below the European Central Bank’s target of just below 2 percent.
This should keep yields in check, according to Mizuho analysts.
“We see downside risks to today’s Germany inflation print. This should contribute to the Bund rally and confirm that peak ECB hawkishness is likely behind us,” they said in a note.
Later in the day, new Federal Reserve Chairman Jerome Powell is due to give his first congressional testimony.
His debut appearance is seen as critical for financial markets at a time when many investors are nervous about the pace of Fed policy normalisation following years of stimulus.
Reporting by Abhinav Ramnarayan; editing by John Stonestreet