October 17, 2017 / 10:28 AM / 5 months ago

UPDATE 2-Bond investors switch to Italy on political and policy outlook

* Italy-Germany bond yield gap at narrowest in over three weeks Italian political breakthrough contrasts with Catalonia concerns

* ECB meets next week, to outline plans for QE

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Writes through)

By Polina Ivanova and Dhara Ranasinghe

LONDON, Oct 17 (Reuters) - Political developments in Italy helped narrow its government bond yield spread over that of Germany to the tightest level in more than three weeks on Tuesday, making it one of the day’s best performers in the euro area.

Most euro zone bonds were in demand on expectations that the European Central Bank will take a cautious approach to winding down its post-crisis stimulus, but gains in Italy’s debt outpaced those of its south European peers.

“In normal times, Italy is not the normal choice for investors in the periphery, regardless of the political outlook,” said Frederik Ducrozet, senior economist at Pictet Wealth Management.

But as domestic political progress there contrasts with trouble in neighbouring Spain, “there’s clearly a case for a short-lived outperformance,” Ducrozet said.

He was referring to the passage of an electoral reform bill through Italy’s parliament last week, which analysts say reduces the chances of the 5-Star Movement leading a government after next year’s election.

Most euro zone bond yields edged lower, but the gap between Italian and German 10-year government bond yields squeezed down to 164 basis points, the narrowest in three weeks.

The yield on Italy’s 10-year government bond was 4 bps lower at 2 percent.

Signs of continuing instability in Spain, which is grappling with a disputed independence vote in Catalonia, has also been favourable for Italian bonds.

Earlier, German government bond yields hit five-week lows ahead of next week’s ECB meeting, when policymakers will discuss the future of its 2.3 trillion euro asset purchase scheme.

By 1530 GMT, those bonds settled at 0.36 percent, still a basis point lower on the day. Other high-grade euro zone bond yields were 1-2 bps lower.

Reports at the end of last week that ECB rate setters were moving towards announcing more asset purchases at lower volumes have fuelled speculation that the central bank will take longer than anticipated to unwind the programme.

“It’s usually the case that markets try to front-run what the ECB will do,” said Orlando Green, European fixed income strategist at Credit Agricole.

“We’re looking for the ECB to cut monthly asset purchases to 40 from 60 billion euros, but indications are that they will go lower for longer.”

In contrast, U.S. bond yields jumped on Monday on reports that Donald Trump met Stanford University economist John Taylor to discuss the job of Fed chair as the U.S. President seeks candidates to succeed Yellen next year.

The gap between U.S. and German 10-year borrowing costs was at its widest in four months at one stage at 194 basis points.

Reporting by Polina Ivanova and Dhara Ranasinghe, Additional reporting by Abhinav Ramnarayan,; editing by John Stonestreet

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