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UPDATE 2-Italian bonds set for best week in two months

* Italy’s 10-year bond yield down 16 bps this week

* Set for biggest weekly drop in 2 months

* German Bund yield briefly hits 2-month low at -0.499%

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Adds comments, updates prices to close)

LONDON, July 24 (Reuters) - Italy’s bond market was poised for its best week in two months on Friday, even as borrowing costs edged up from 4-1/2 month lows set after this week’s agreement on a European Union recovery fund to support economies hit hard by the coronavirus.

Bond yields across the euro zone rose after data showing euro zone business activity recovered in July and signs of rising U.S./China tensions prompted investors to take profits on this week’s price gains and yield falls.

Italy’s 10-year bond yield rose 2 basis points to 1.07% , off Thursday’s low of around 1.04%.

Still, Italian yields are down about 16 bps this week, set for their biggest weekly fall in two months. According to Tradeweb data, 10-year Italian bond yields dipped below 1% on Thursday for the first time since March.

Spanish and Portuguese 10-year bond yields are down around 6 bps each this week , Greek yields have tumbled 10 bps.

“The impact of the recovery fund wasn’t fully priced in and not still fully priced,” said Peter Chatwell, head of multi-asset strategy at Mizuho. “The structural part of the story is that it allows euro break-up risk to diminish to levels that have not been seen for some time.”

In Germany, yields rose from two-month lows after the euro zone flash Composite Purchasing Managers’ Index (PMI), seen as a good indicator of economic health, rose to 54.8, its highest since mid-2018 and above forecasts. June’s final reading was 48.5.

The 10-year Bund yield was last up 4 bps at -0.44% , having briefly touched a two-month low in early trade at around -0.50% as German bonds too benefited from renewed optimism towards the euro area.

Three forces appear to be in play - the strong fiscal response, aggressive stimulus from the European Central Bank and perceptions of a better handling of the health crisis versus the United States.

This has also helped boost the euro to 21-month highs against the dollar this week.

EU leaders on Tuesday agreed to a 750 billion-euro recovery fund, which Italy’s Prime Minister Giuseppe Conte said would allow his government to transform Italy. Italy and Spain, two of the countries hardest hit by the pandemic, are among the biggest beneficiaries of the deal.

“We think the Recovery Fund is a key ingredient for the European response to the shock. The ECB helps address the large funding needs but it can’t replace every foreign investor in the periphery,” analysts at BofA said in a note.

Reporting by Dhara Ranasinghe; editing by Larry King and Steve Orlofsky

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