September 25, 2018 / 8:15 AM / in a month

UPDATE 3-Italy's bond yields tumble on budget hopes, Bund yields rise

* German bond yields at four-month highs

* ECB’s Praet plays down expectation of faster rate hike cycle

* Markets bring forward expectations for ECB rate hike to Sept

* Italy bond yields fall on hopes of budget deal

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates pricing, adds quote)

By Dhara Ranasinghe and Virginia Furness

LONDON, Sept 25 (Reuters) - Italian borrowing costs fell sharply on Tuesday, narrowing the gap with German peers, on signs the country’s anti-establishment coalition is likely to reach a compromise over its 2019 budget.

In contrast, German bond yields rose to four-month highs, as a bearish tone in broader bond markets lingered a day after European Central Bank chief Mario Draghi pointed to a “vigorous” pick-up in underlying inflation.

Italy’s ruling coalition, made up of the 5-Star Movement and the League party, is willing to keep its budget deficit below 2 percent of gross domestic product, a government source told Reuters.

Italy’s La Stampa reported that the government will offer a 2019 deficit plan of 1.9 percent of GDP this week, including a 36 billion euro ($42 billion) investment package. The government must present its budget targets this week.

“It looks like a compromise is taking shape,” said Martin van Vliet, senior rates strategist at ING. “Everyone assumes it (the deficit forecast) will be around 2 percent.”

Italian bond yields were down 7 basis points, having fallen as much as 12 basis points earlier in the day . The move reversed most of the rises made after Draghi’s speech on Monday.

Italy’s 10-year bond yield was at 2.89 percent percent, having hit a two-week high at 2.96 percent on Monday. This shrank the spread over benchmark German Bund yields to around 232 bps, from around 245 bps late on Monday.

Its five-year bond yield fell 7 bps to 1.90 percent, having recorded its biggest one-day rise since Aug. 13 on Monday. ,.

DRAGHI SURPRISE

Outside Italy, most euro zone bond yields were 1 to 3 bps higher. French 10-year bond yields hit their highest in over three months.

ECB chief economist Peter Praet played down speculation the ECB was getting ready to tighten policy more quickly. ECB policy will need to remain accommodating for a long time to come, he said.

Praet’s comments saw euro zone bond yields briefly ease off Tuesday’s highs, but yields soon headed back higher, suggesting that investors still expect the tightening cycle to start sooner rather than later.

Money market pricing suggests investors now expect a rate rise next September instead of October 2019.

“There’s a dichotomy in communication in forward guidance (by saying we’re) not going to touch rates (for a while), and the economic assessment which is positive. The economy is growing, inflation is close to target and in theory this should justify tightening policy,” Mizuho rates strategist Antoine Bouvet said, explaining why Praet’s comments had had little impact.

Analysts said a rise in oil prices to four-year highs had also added to the bond selloff.

In Germany, 10-year bond yields rose to a four-month high at 0.55 percent, a day after posting their biggest one-day jump since June.

The rise in 10-year bond yields left the German curve at one point at its steepest in three months.

“Draghi’s comments were the trigger for the bond sell-off and the market is very sensitive on the back of that,” Commerzbank rates strategist Michael Leister said.

Investors are bracing for higher interest rates globally as major central banks unwind massive stimulus injected into world markets in the wake of the financial crisis. U.S. 10-year yields rose to a four-month peak.

The U.S. Federal Reserve kicks off a two-day meeting on Tuesday and is widely expected to hike rates this week. This follows the Bank of Japan’s move to trim its bond purchases last week. ($1 = 0.8498 euros)

Reporting by Dhara Ranasinghe and Virginia Furness Editing by Robin Pomeroy

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