December 17, 2018 / 12:20 PM / in 2 months

UPDATE 2-Italian, French bonds diverge as political worries shift from Rome to Paris

* French deficit likely to be 3.2 pct of GDP - PM

* Italian coalition agrees revised budget terms

* France/Germany yield gap near widest level since mid-2017

* Euro zone periphery government bond yields tmsnrt.rs/2ii2Bqr (Updates pricing throughout, adds chart)

By Abhinav Ramnarayan

LONDON, Dec 17 (Reuters) - Italian bond yields remained near recent lows on Monday as chances of a rapprochement with the European Union grew, but French borrowing costs rose as “yellow vest” protests rumbled on.

Italy’s coalition government has agreed on the “numbers and contents” of the budget it will propose to Brussels in a bid to avoid disciplinary action over its planned deficit spending next year, a spokeswoman for the ruling League party said.

In France, Prime Minister Edouard Philippe told newspaper Les Echos the deficit was likely to overshoot the EU limit of 3 percent of GDP next year to about 3.2 percent.

“The focus is a bit more on France now - investors are waiting for the revision of the French deficit after the spending measures announced by Macron,” said Natixis strategist Cyril Regnat.

France saw the fifth weekend of demonstrations against President Emmanuel Macron’s government, and though protests were noticeably smaller, shops were still closed.

Macron last week announced tax cuts for pensioners and a minimum wage increase, in an effort to defuse the unrest.

“The net issuance target for OATs (French government bonds) next year is about 195 billion euros. If they have to increase it, then the market reaction would be even more negative,” Regnat said.

Should France’s budget deficit considerably breach EU budget rules, it will make it more difficult for Brussels to strong arm Italy into compliance, said Rabobank rates strategist Matt Cairns.

“At what point do the populists (in Italy and elsewhere) point the finger back at France?” he said.

French government bond yields rose two basis points to 0.73 percent, pushing the France/Germany 10-year bond yield spread up to 47 bps, near last week’s 1 1/2-year high.

Italian bond yields fell at one point before reversing those price gains to trade flat on the day.

The Italy/Germany 10-year yield spread was at 269 basis points, not far from last Thursday’s 2-1/2-month low of 261 bps and well away from November’s high of 326 bps.

Particularly notable is German yields’ recent drop on downbeat growth and inflation expectations. Ten-year yields, at 0.26 percent, are about half their level of two months ago.

However, Regnat of Natixis warned that Italy’s revised budget has to pass a few more stages before receiving EU approval.

“To me it’s more short-term relief at this stage and investors will be reassessing Italian risk in January,” he said.

Other euro zone bond yields were mostly unchanged on Monday following the release of final inflation numbers, which showed consumer prices in the 19 countries sharing the euro eased 0.2 percent month-on-month in November for a 1.9 percent year-on-year increase. This was a revision down from the previously reported 2.0 percent.

A market gauge of long-term euro zone inflation expectations remain close to recent lows at around 1.623 percent.

Reporting by Abhinav Ramnarayan, additional reporting by Virginia Furness; Editing by Richard Balmforth and Andrew Cawthorne

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