* Italy-German yield spread narrows as political worries ease
* But PIMCO warns of wide range of risks to come in Italy
* BoE’s Carney reinforces benign monetary policy backdrop
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds 5-Star on euro referendum in pars 2 and 8)
By Abhinav Ramnarayan
LONDON, June 20 (Reuters) - The gap between Italian and German 10-year borrowing costs hit its narrowest level in five months on Tuesday as euro zone bond investors priced in what they see as a dramatic reduction in the risk of the bloc breaking up.
The latest dip in Italian yields came as the anti-establishment 5-Star Movement said its plan to hold a referendum on Italy’s euro membership was “a negotiating tool”.
Earlier this year, government bond yields in southern Europe rose due to uncertainty over how French elections in May would play out, the possibility of a snap vote in Italy and speculation of the European Central Bank beginning to wind down its extraordinary monetary stimulus.
Since then, however, the ECB has indicated it is in no hurry to end its programme, centrist Emmanuel Macron beat anti-euro far-right leader Marine Le Pen to become French president, and fears have faded of Italy facing a potentially disruptive election.
“The perception in the market is that the main political risks that were the dominating factors (in euro zone bond markets) are now behind us,” said DZ Bank strategist Christian Lenk.
“Investors are now happy to take some carry into the summer months.”
The Italian-German bond yield spread, closely watched as a key indicator of political risk in the bloc, tightened to 165 basis points, its narrowest level since early January.
Italian 10-year yields fell late on Tuesday to as little as 1.914 percent, a five-month low and down 3.8 bps on the day.
The 5-Star movement’s plan for a referendum on whether Italy should remain in the euro was Plan B, a leading deputy said.
“Big investors and markets should be able to distinguish it from the real intentions of a 5-Star government on the subject of the euro,” Carla Ruocco told Reuters.
However, the fall in yields prompted a note of caution from the world’s largest bond investor.
“You need to be generous to fund Italy at 2 percent given a wide range of risks that are coming,” Andrew Balls, chief investment officer for global fixed income at PIMCO, told a Euromoney conference in London.
Italy will face elections in 2018, with 5-Star riding high in opinion polls.
There is also the possibility of a state bailout to support some of its ailing banks at a time when the debt-to-GDP ratio is over 130 percent.
Spanish 10-year yields also fell, down 5 bps on the day to 1.393 percent, their lowest in about a week.
The promise of continued monetary stimulus is also positive for lower-rated bonds in the bloc, and indications are that central bankers in major developed countries are all hesitating to tighten monetary policy.
On Tuesday, Bank of England Governor Mark Carney said now was not the time to raise interest rates.
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Additional reporting by Dhara Ranasinghe; Editing by Hugh Lawson and Ed Osmond