February 14, 2018 / 9:02 AM / a year ago

Southern European debt in demand as strong economy returns to spotlight

* Italian, Spanish, Portuguese bonds outperform

* German, Dutch GDP growth positive, Italian data due

* Core yields lower ahead of U.S. inflation numbers

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

By Abhinav Ramnarayan

LONDON, Feb 14 (Reuters) - Southern European government bonds were in demand once again on Wednesday ahead of the release of euro zone economic numbers that are expected to bring comfort to investors who have been shaken by political concerns.

Italian, Spanish and Portuguese bond yields dropped 2-4 basis points, comfortably outpacing better-rated peers, with the euro zone expected to record growth of 2.7 percent year-on-year in the last quarter of 2017, according to a Reuters poll.

In addition to broad numbers for the bloc as a whole, Italian GDP numbers are also due while the Netherlands and Germany both reported strong growth earlier in the session.

“These hard economic indicators ought, yet again, to corroborate the decidedly positive picture being painted by the leading indicator readings,” DZ Bank analysts said in a note.

Italian numbers in particular ought to help sentiment towards a country that is due to hold a general election in less than a month, with euro-sceptic parties likely to be part of a new government.

Expectations are for Italy to report economic growth of 1.6 percent year-on-year for the fourth quarter of 2017, according to a Reuters poll.

Italy’s 10-year government bond yield dropped 3.5 basis points to 2.04 percent, and the bond yield spread over Germany narrowed to 131 basis points.

Spanish and Portuguese counterparts were down 3-5 bps.

This after that Italy-Germany bond yield spread had widened 17 bps in the past week as concerns over politics in Germany and Italy resurfaced.

The potential collapse of a German coalition agreement that investors believed would have favoured Southern European countries was the primary driver of that widening.

Concerns over the strength of eurosceptic parties in Italy ahead of an election on March 4 may have also contributed.

The Northern League, a key partner in the coalition expected to win next month’s parliamentary election, would aim to pull Italy out of the European Union if Brussels refused to re-negotiate fiscal and immigration rules, its economics chief said.

As the session progresses, U.S. inflation numbers are likely to be the main driver for yields, particularly among better-rated bonds.

Across the developed world, strong growth has so far had little impact on inflation, thereby making it difficult for central banks to tighten policy as expected.

“Markets have priced in rate hikes by the Fed and change in guidance by the ECB all based on the assumption we will have a shift towards higher inflation,” said DZ Bank strategist Daniel Lenz.

“But we cannot be sure this is a trend yet - but the market will react if we see some evidence of that in today’s data,” he said.

Germany’s 10-year government bond yield was lower 1.5 bps to 0.72 percent ahead of this release, dropping further away from multi-year highs of 0.81 percent hit last week.

Earlier this month, data showed U.S. wages recorded their largest annual gain in more than 8-1/2 years, bolstering expectations that inflation will push higher this year. (Reporting by Abhinav Ramnarayan; Editing by Alison Williams)

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