December 3, 2018 / 8:48 AM / 7 days ago

UPDATE 3-Trade truce, Italy budget compromise hopes send Italian yields tumbling

* Italy yields fall sharply

* Trade truce, Italy budget headlines boost Italy bonds

* German yields pull back from over 3-month lows

* ECB adopts new capital key, Italian share trimmed (Updates prices)

By Dhara Ranasinghe

LONDON, Dec 3 (Reuters) - Italy’s borrowing costs tumbled to their lowest level in just over two months on Monday after two newspapers reported that Rome was negotiating with the EU to reduce its 2019 target for the budget deficit to 2.0 percent of GDP or even below.

As the session wore on, Italian debt was boosted further by the European Central Bank’s announcement of a new capital key, which trimmed Italy’s share less than expected.

Also, news that U.S. President Donald Trump and Chinese President Xi Jinping agreed to halt new tariffs during talks in Argentina on Saturday, following months of escalating tensions on trade and other issues, fuelled demand for risk assets such as Italian government bonds.

Yields on two-year Italian debt fell 18 basis points to 0.67 percent, their lowest level in 2-1/2 months.

Five-year Italian debt yields tumbled 17 bps to 2.16 percent. Ten-year yields fell to two-month lows at 3.14 percent, narrowing the gap over German Bund peers to its tightest in around two months.

Italy’s bond market has bounced back in recent weeks on signs that the country’s anti-establishment government is willing to reach a compromise with the European Union over its budget plans for next year.

In response to a question about whether Italy is negotiating a reduction in the deficit-to-GDP ratio to 2.0 percent or 1.9 percent from a present target of 2.4 percent, La Repubblica daily on Monday quoted Italian Finance Minister Giovanni Tria as saying: “Yes, these are the figures.”

“They (the Italian government) do seem keen to get a compromise and this is helping the risk mood towards BTPs today,” said Martin van Vliet, senior rates strategist at ING.

BUND SELLING LIMITED

Germany’s 10-year Bund yield jumped as much as 4 bps to around 0.35 percent, but drifted back down following weak data and the ECB announcement on the capital key.

Data showing euro zone manufacturing activity expanded at its weakest rate in over two years in November provided further evidence that the bloc’s economic growth is past its peak.

Analysts added that a note of caution on what to expect in terms of global trade talks, political developments in the bloc and next week’s vote in the British parliament on Prime Minister Theresa May’s Brexit deal limited selling of safe-haven German debt.

Reporting by Dhara Ranasinghe; Editing by Gareth Jones

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