November 30, 2018 / 10:54 AM / 6 months ago

UPDATE 2-Euro zone bond yields hold near three-month lows after inflation drop

* German bond yields near three-month lows

* Euro zone core inflation weaker than expected

* Italian GDP contracts in Q3 for first time

* Junker says “We are not at war with Italy”

* Italian bonds take a breather after this week’s falls

* Euro zone periphery govt bond yields (Updates prices, adds detail on Italian GDP, Junker comments)

By Tommy Wilkes

LONDON, Nov 30 (Reuters) - Euro zone government bond yields traded near three-month lows on Friday, pinned lower by a fall in core inflation, while Italian debt was steady after expectations for a budget compromise with the European Union sent them lower this week.

Analysts said markets had already priced in the drop in euro zone price growth in November, with German government bond yields hitting their lowest in over three months on Thursday.

Euro zone core inflation for November, which is closely followed by the European Central Bank, fell to 1.1 percent, against expectations for a rise.

Consumer prices in the 19 countries sharing the euro rose by 2.0 percent year-on-year in November after a six-year high of 2.2 percent in October as food and energy price hikes eased, the data showed.

Sliding oil prices in the last few months are slowing price growth in some countries, although in the euro zone’s largest economy energy prices have risen.

A fall in U.S. Treasury yields on Thursday had fuelled a rally in core euro zone government bonds, as investors bet the European Central Bank could be forced to keep interest rates at record lows for longer because of economic headwinds.

Federal Reserve Chairman Jerome Powell also gave comments that many investors saw as a sign the U.S. Fed’s tightening cycle was drawing to a close.

“The reason the Bund is not rallying that much on the back of these figures is that it has already been priced in. The yield has already been dropping for a while now, heading towards the 30 basis point, where there should be some resistance,” said Cyril Regnat, an fixed income strategist at Natixis.

“The market will now be waiting for the G20 this weekend and that could be a reason why bonds are stabilising.”

The 10-year German government bond hit its lowest point since Aug. 21 at 0.305 percent before pulling back to 0.312 . The 5-year bond was also close to a three-month low at -0.269 percent.

Other core euro zone bond markets in France and Austria were down around 1.5 basis points with France’s 10-year government bond reaching its lowest point since August 27 at 0.676 percent.

In Italy, yields largely held on to the strong gains notched up this week despite data showing that Italy’s economy had contracted in the third quarter for the first time in four years due to falling domestic demand.

However, more a more positive tone from European Commission Jean-Claude Junker on Italy’s budget likely gave a boost to bond prices. Juncker said on Friday the EU executive was making progress in talks with Italy over the country’s budget.

Italy’s government has been targeting a deficit of 2.4 percent of gross domestic product in 2019, putting it on a collision course with Brussels.

“It’s encouraging that there are signs some members of the government are pushing for a 2 percent deficit target,” said Antoine Bouvet at Mizuho, predicting a rally in Italian bonds into the year-end so long as there are no more adverse headlines.

The Italian 10-year bond yield rose 1.5 basis point to 3.215 , while the 5-year rose 1.3 basis points to 2.343 percent. (Additional reporting by Abhinav Ramnarayan; Editing by Alison Williams)

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