May 24, 2018 / 7:59 AM / 6 months ago

UPDATE 2-Italy's bond market wins respite but outlook uncertain

* Italy bond yields tumble

* Italian/German bond yield gap 10 bps tighter

* Core euro zone bond yields higher

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates throughout)

By Dhara Ranasinghe

LONDON, May 24 (Reuters) - Italy’s government bond yields tumbled on Thursday, as the market won a respite from the political risks that have dealt investor sentiment a heavy blow over the past week.

On Wednesday, President Sergio Mattarella gave political novice Giuseppe Conte a mandate to lead the first government in Italy made up of anti-establishment parties, who have vowed to shake up the European Union and spend big.

Analysts said hopes that a eurosceptic will not become the next economy minister helped Italian bonds to recover, although the market remained vulnerable.

The League has said it wants eurosceptic economist Paolo Savona to take the economics position - a suggestion that had added to market alarm over Italy’s direction.

But a source spoke to Mattarella about the eventual government line-up told Reuters the head of state was unhappy about having a eurosceptic as economy minister. And the president has veto power over ministerial appointments.

“The more important driver for markets is cabinet choices, especially the economy minister,” said Commerzbank rates strategist Rainer Guntermann.

“It seems the market is taking on board that the choice for economy minister may not be as hard-line as feared, which is why we’re getting some reversal of yesterday’s moves. But the bigger picture is still unclear.”

Italy’s 10-year bond yield fell 9 basis points to 2.32 percent, below Wednesday’s 14-month high at around 2.46 percent.

It was set for its biggest daily fall in seven months.

The Italian/German 10-year bond yield gap was almost 10 bps tighter at 180 bps.

A sustained rise in Italian 10-year yields above 2.4 percent could cause wider contagion via local banks’ holdings of government debt, Morgan Stanley said on Thursday.

Chris Scicluna, Daiwa Capital Markets’ head of economic research, said a key test for markets will be the next government’s budget proposals.

“If we get a provocative finance minister, that could cause some alarm, but the proof is in the pudding and we’ll see that when we get the budget proposals,” he said.

Indebted euro zone governments that loosen the purse strings risk falling out of favour with investors, particularly if economic growth slows, the European Central Bank said on Thursday.

Former Italian prime minister Silvio Berlusconi, meanwhile, said his Forza Italia party would vote against the coalition government of the 5-Star Movement and League in a parliamentary confidence motion expected next week.

Thursday’s recovery in Italian bonds pushed down Spanish and Portuguese yields 4-5 bps each .

China continues to buy European debt and is a long-term investor in the euro, Premier Li Keqiang said on Thursday .

Other euro bond yields rose following sharp falls on Wednesday after weaker-than-expected business activity data renewed concerns about the outlook and the ECB’s plans to exit quantitative easing.

The ECB can still end its bond-buying programme later this year, two policymakers said on Wednesday.

German Bund yields were last up 2 bps at 0.52 percent , off Wednesday’s 5-week low.

Reporting by Dhara Ranasinghe, editing by Larry King

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