June 29, 2018 / 10:47 AM / 18 days ago

UPDATE 2-Migration deal knocks German Bunds, lifts Italian bonds

* EU struggles to bridge rift over migration

* But vague agreement eases fears of German govt collapse

* Euro zone inflation hits 2 pct in June

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

By Dhara Ranasinghe

LONDON, June 29 (Reuters) - Italian government bond yields dropped sharply across the board after a deal among European Union leaders to tackle migration eased fears of no accord and averted a potential clash between Italy’s new populist government and the European Union.

Italy’s 10-year borrowing costs fell to a one-week low at 2.69 percent as the deal lifted sentiment towards the euro zone’s riskier assets and allayed concerns around a three-month-old German government.

Tense negotiations ended in a deal to set up joint asylum processing sites and restrict migrant movements within the EU, but the bloc’s leaders made clear that virtually all their pledges would be carried out by member states on a “voluntary basis”.

“The outcome of the summit tells us something about the severity of the situation,” said Jan von Gerich, chief analyst at Nordea in Helsinki.

“I’m not confident it will solve the underlying issues but there was a fear that the summit would fail and we could get a collapse of the German government, so that risk premium is being priced out,” he said.

Germany’s 10-year bond yield rose as much as 2.5 basis points to 0.34 percent, before drifting back down after inflation data from the currency bloc showed underlying price pressures remain subdued. It was set to close the week around 0.31 percent.

German yields were set to end June virtually flat, after falling 22 bps in May as Italian political worries gripped the markets. German debt is seen as one of the world’s safest assets.

While the migration deal lifted hopes that a row over migration policy within Germany’s coalition government could now be resolved, it also boosted optimism about the new Italian anti-establishment government’s ability to reach a compromise with EU partners.

“When the Italian coalition was formed, there was a significant building-in of a risk premium on a view that there were clear grounds for conflict between Italy and the EU,” said MUFG’s European head of global markets research Derek Halpenny.

“Going into this summit even yesterday, (German Chancellor Angela) Merkel was saying we wouldn’t get a deal. It would now appear at least in part that Italy is willing to sit down at the table and compromise.”

The euro firmed after the migration deal and was up 0.85 percent against the dollar, while European shares climbed over 1 percent.

Data showed euro zone inflation rose to its highest rate in more than a year in June, above the European Central Bank’s near 2 percent target.

But in a sign that underlying inflation is still muted, price growth excluding volatile food and energy costs slowed, capping a rise in bond yields.

Elsewhere, Greek 10-year bond yields touched their lowest in almost seven weeks at 3.957 percent, extending falls made after a recent debt relief agreement.

HSBC said on Friday it recommended buying five-year Greek government bonds after the country won a debt relief deal.

Reporting by Dhara Ranasinghe Editing by Mark Heinrich

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