December 28, 2018 / 12:25 PM / 6 months ago

UPDATE 2-Italian bond yields hit 3-1/2 month low after strong auction

* Italy sells maximum of 5 billion euros in bond auction

* 10-year Italian yield drops to 2.71 percent

* German, Spanish inflation below ECB target level

* Euro zone periphery government bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds German inflation numbers, stock moves)

By Abhinav Ramnarayan

LONDON, Dec 28 (Reuters) - (There will be no London-based bond report on Monday, December 31, as Eurex is closed for trading of bond futures.)

Italy’s benchmark government bond yield hit its lowest in 3-1/2 months on Friday after the country’s 10-year funding costs dropped sharply at a debt auction that drew strong demand.

The auction was seen by investors as a signal that Italy had turned a corner after agreeing steps to resolve a row over spending plans with Brussels that had roiled markets for months.

“We are no longer at a stage where Italy should have any issues selling bonds, though I think we can see that there’s still preference for the liquidity points in the curve,” said Mizuho strategist Antoine Bouvet.

Soon after the auction, Italy’s 10-year government bond yield dropped to 2.71 percent, its lowest since Sept. 11, before settling at 2.75 percent by the close.

The Italy/Germany 10-year yield spread tightened to 249 basis points, also the lowest since mid-September, before widening to 251 bps.

Five-year Italian yields were set to close 1 basis point lower at 1.81 percent.

Political turmoil, turgid growth prospects and worries over the future of the euro have made this one of the most difficult years for the Italian Treasury to fulfil its big borrowing programme.

But the agreement between Italy and the EU on a budget plan for 2019 has led to a sharp rally in Italian bonds, and 10-year yields have dropped 49 bps in December, the biggest monthly fall since July 2015.

Elsewhere, annual inflation in Germany slowed sharply in December, slipping below the European Central Bank’s target level just as the bank ended a crisis-fighting bond purchase scheme after four years.

Spanish inflation missed expectations, coming in at 1.2 percent for the month of December compared to forecasts of 1.6 percent.

A key market gauge of long-term inflation expectations tracked by the ECB, the five-year, five-year breakeven forward, fell to 1.5639 percent, a 17-month low.

Both German and Spanish 10-year government bond yields rose 1-3 basis points on the day as a stock market recovery took away some of the safety bid for the debt.

A relief rally across equities gathered pace in Europe with the STOXX 600 rising 1.9 percent, the strongest daily gain since April. (Reporting by Abhinav Ramnarayan; Editing by Kevin Liffey and John Stonestreet)

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