* Bund yield falls towards its lowest since September 2017
* Collapsed Brexit talks prompt scramble for Gilts
* Spain, French bonds set for best week in 2 months
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates with latest prices)
By Dhara Ranasinghe
LONDON, May 17 (Reuters) - German bond yields fell back towards more than 2-1/2 year lows on Friday as the collapse of Brexit talks in Britain boosted higher-rated debt and worsened a mood among investors already nervous about trade tensions.
Both French and Dutch 10-year government bond yields touched 2-1/2 year lows.
Talks between Britain’s two biggest parties over a Brexit deal collapsed, reviving doubts whether Britain can avoid leaving the European Union without a deal.
The opposition Labour party blamed Prime Minister Theresa May’s crumbling government, and investors are now bracing for a contest to succeed her.
“It’s the additional uncertainty that’s been injected into the market as a result of the likely leadership campaign and the real lack of clarity about what that means for Brexit,” said Sarah Hewin, an economist at Standard Chartered, pointing to the renewed prospect of a no-deal Brexit and a possible national election.
The 10-year British government bond yield dropped almost six basis points. The benchmark German 10-year bond yield touched as low as -0.129%, near -0.132%, its lowest since September 2017 that was hit on Wednesday.
Adding to the nervousness, rising trade tensions between the United States and China, the world’s two biggest economies, have fuelled concern about global growth. Tough words on trade from China’s media on Friday drowned out upbeat news on the U.S. economy and corporate earnings,
U.S. Treasury yields, which rose on Thursday after the strong U.S. data, also fell.
French and Spanish 10-year bond yields were set for their biggest weekly drop in about two months, down 14 and 11 bps respectively.
There have been steep falls in yields across major bond markets this year as weaker global growth and a shift to a more dovish stance from central banks creates a favourable backdrop for fixed income.
“Bond markets in general, especially (German) Bunds, are telling us they don’t see many good things going on in the next one (to) two years,” said Neil Dwane portfolio manager and global strategist at Allianz Global Investors.
Renewed concern about Italy, the euro zone’s third-biggest economy, and its spending plans has also fuelled demand for safer assets, although there was some respite for Italian bonds on Friday, with those yields down as much as 11 basis points before recovering towards the end of the European session.
Analysts said this was more down to position-covering ahead of the weekend than any major easing in concern about Italian risks, however.
Deputy Prime Minister Luigi Di Maio said on Friday he was not worried over possible EU sanctions in case of a violation of fiscal rules, as he was confident European leadership would change after this month’s European parliament elections.
Investors have been on edge since Deputy Prime Minister Matteo Salvini said on Tuesday that Rome should be ready to break an EU deficit ceiling of 3% of gross domestic product and push debt to 140% of GDP if needed to fight unemployment.
Reporting by Dhara Ranasinghe; Additional reporting by Sujata Rao and Tommy Wilkes; Editing by Hugh Lawson, John Stonestreet, William Maclean