* Italy 10-year bond yields rise to 2-1/2 month highs
* Italy/Spain 10-year yield gap near widest since mid-Feb
* Ten-year German Bund yield falls on trade war fears (Updates with move in German bonds)
By Virginia Furness
LONDON, May 13 (Reuters) - Italian government bonds yields rose to their highest level in 2-1/2 months on Monday as risk aversion caused by deteriorating U.S.-China trade tensions and worries about political infighting in Rome fuelled a selloff.
Germany’s benchmark 10-year bond yield hit a six-week low after China said it would impose higher tariffs on a range of U.S. goods, sparking a rush into safe-haven assets. “Ultimately the longer the prevailing trade tensions are extending, the heavier the impact on tariffs and economic growth globally,” said Rabobank fixed income strategist Matthew Cairns.
Italian bond yields rose after last week’s warning from the European Commission that public finances would deteriorate further and politicians in Rome raised the possibility that Italy could breach EU rules on public spending unnerved investors.
Analysts said they expected public discord between the two ruling Italian parties to grow in the run-up to European elections later this month.
Italy’s 10-year bond yield briefly rose to a 2-1/2 month high at 2.74% before pulling back in late trade to around 2.70%. It rose 13 basis points last week in the biggest weekly selloff in three months.
The Italy/Spain 10-year bond yield gap held close to its widest since mid-February and was last seen at 172 bps .
Germany’s 10-year government bond yield fell 2.5 bps to its lowest in around six weeks at minus 0.074%, as China fought back in its trade war with the United States.
Short-dated U.S. Treasury yields fell 7 bps to 2.18%, squeezing the gap over two-year German bond yields to around 281 bps - its tightest since March .
Investors are watching the Italian political situation closely after Italy’s coalition government vowed last week to patch up their differences and govern for four more years.
But support for Italy’s far-right League party has fallen following the weeks of feuding with its coalition partner the 5-Star Movement, opinion polls showed on Friday.
Commerzbank rates strategist Rainer Guntermann cited the political news flow and fear over the rising deficit for the selloff, but noted that the budget discussion will likely be postponed until after the European elections.
“The Commission is in a vacuum ahead of the election ... and this will heat up later this year when we get the official reporting in Europe,” he said.
The European Commission last week cut Italy’s growth forecast to 0.1%, down from 0.2%, and said the country’s deficit could widen beyond the 3% ceiling set by the European Union.
Italy’s government tested investor patience, as well as that of the EU, last year by trying to push through a budget which breached EU deficit rules.
Lawmakers are once again mounting a challenge to EU fiscal rules. Italy’s Deputy Prime Minister Luigi Di Maio said on Friday the European Union’s fiscal rules should be changed to allow more public spending on health, research and education.
Investors will be able to have their say on the outlook for Italy on Tuesday, when its Treasury auctions up to 6.75 billion euros of bonds.
Reporting by Virginia Furness; Additional reporting by Tommy Wilkes and Dhara Ranasinghe; Editing by Alison Williams