* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices)
By Yoruk Bahceli
AMSTERDAM, July 20 (Reuters) - Italy’s borrowing costs fell to their lowest since early March on Monday as signs of a potential deal started to emerge from a fraught European Union summit aimed at agreeing a 750 billion euro ($860 billion) economic recovery fund.
The proposed fund, which envisions liability sharing by offering grants to the worst-hit states, has been a key driver of a rally in southern European bonds led by Italy since May, following an initial, similar Franco-German proposal.
The summit, originally scheduled for Friday and Saturday, stretched into Monday as fiscally hawkish countries led by the Netherlands balked at the size of grants to the worst-affected states and demanded handouts be conditional on economic reforms.
But signs emerged of a possible deal around the grants being reduced to 390 billion euros, a compromise between the 350 billion euros backed by the “frugal” states and the 400 billion euros demanded by France and Germany. The summit was adjourned on Monday until 1400 GMT.
After markets last week expected a decision to be delayed, Italian bonds rallied on the progress.
“I think more important than the size of the package at the moment is the fund being implemented (at all),” said Peter Chatwell, head of multi-asset strategy at Mizuho in London.
Italian bonds extended gains after German Chancellor Angela Merkel said a deal was possible on Monday and French President Emmanuel Macron said a compromise was likely.
Italy’s 10-year yield fell eight basis points to its lowest since March 9 at 1.158%, wiping out much of the coronavirus sell-off that drove it as high as 3%.
Two-year Italian yields dropped into negative territory for the first time since early March.
That reduced the closely watched risk premium Italy pays for 10-year debt on top of Germany to its lowest since late March at 160 bps.
Markets have been encouraged by the potential compromise, said Hetal Mehta, European economist at Legal & General Investment Management, which manages 1.2 trillion pounds.
“The fact that they have now moved onto a fourth day of negotiations shows real determination,” she said.
“Just because they’ve reduced the grant size, they haven’t reduced the overall size of the package. So, what they’re planning on cutting on the grant side could actually be added to the loans component.”
But Mizuho’s Chatwell warned that negative headlines around conditionality could undo some of the gains in later trade.
“If there are more rigid and unpalatable conditionalities, which relate more to stability and growth pact-type conditions, or conditions which are normally associated with a bailout deal, that would hit the breaks on positivity.”
Safe-haven German 10-year yields were down slightly to -0.46%.
($1 = 0.8725 euros)
Reporting by Yoruk Bahceli; Editing by Catherine Evans