* Italian bond yields tumble, data shows drop in bad loans
* Data brings respite after week-long selloff
* German Bund yields pull back from over 2-year lows
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds bullets, move in USTs)
By Virginia Furness
LONDON, Feb 11 (Reuters) - Italian government bonds outperformed the rest of the euro zone debt market on Monday, with yields falling after the Bank of Italy data showed banks shed more than 17 billion euros in gross bad loans in December.
Support for riskier assets was reflected in a sell-off in core euro zone paper, with Germany’s 10-year bond yield rising three basis points to 0.11 percent, having dropped as low as 0.077 percent on Friday. Progress in China-U.S. trade talks had lifted sentiment, analysts said.
Italian two- and five-year bond yields fell over 10 bps each after the Bank of Italy reported a 34 percent year-on-year fall in impaired loans. Net of writedowns bad loans stood at 30 billion euros in December, the lowest level since May 2010.
Bad loans held by Italian banks swelled to 360 billion euros in 2015-2016 following a deep recession and lenders have been working to reduce them in the past two years.
Italian banking stocks rallied almost 1.9 percent .
The boost to Italian bonds from the data came despite pressure from the government on the Bank of Italy and the expectation of early elections, Commerzbank rates strategist Christoph Rieger said.
“(Deputy Prime Minister Matteo) Salvini is seeing the chance of becoming Prime Minister looking at some of the recent surveys,” he said. “This won’t abolish uncertainty but the markets will probably take it well.”
Italy’s populist leaders on Saturday promised to replace top officials at the country’s central bank.
The bond rally also comes despite expected pressure on the Italian government for further fiscal adjustment following the European Commission’s downwards revision last week of its growth forecast for Italy.
ING analysts said the EU will want to avoid reopening the discussion ahead of EU parliamentary elections in May and as such do not expect any action on the Italian budget yet.
Fitch is due to review Italy’s credit rating on February 22.
The Italian/German 10-year bond yield gap narrowed to around 279 bps having edged closer to 300 basis points on Friday .
Demand for core euro zone bonds waned as progress in trade talks between China and the U.S. boosted risk appetite.
In late trade, most 10-year euro zone bond yields were 2-3 bps higher on the day,. U.S. Treasury yields also rose as the U.S. session got underway.
The prospect of early elections in Spain had little immediate impact on the Spanish curve. The Spanish/German 10-year bond yield gap was at around 112 bps having briefly widened to almost one-month highs at around 114 bps earlier.
Around 14 billion euros of new supply is expected this week with the Dutch treasury due to kick of issuance with a new 2029 bond on Tuesday. (Reporting by Virginia Furness; Editing by Kirsten Donovan)