May 10, 2018 / 8:16 AM / 2 months ago

UPDATE 3-Politics shakes up Italian bonds, yields at seven-week high

* Fiscal concerns pressure Italian bond yields higher

* Bank of England keeps rates steady

* US inflation weaker-than-expected

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds US CPI)

By Saikat Chatterjee

LONDON, May 10 (Reuters) - Italian government bond yields rose to seven-week highs on Thursday on growing expectations that anti-establishment parties will take power in the euro zone’s third largest economy.

Benchmark 10-year Italian government bond yields jumped as much as 6 basis points to 1.94 percent and the spread between Italian debt and its German counterpart stretched to its widest in six weeks at 138 basis points..

The anti-establishment 5-Star Movement and far-right League have made “significant steps” towards forming a government, the two parties said on Thursday as Italy looked to end nine weeks of political deadlock.

The 5-Star movement had been signalling for weeks it was ready to form a coalition with the League, but not with its ally, former prime minister Silvio Berlusconi. Late on Wednesday, Berlusconi accepted a demand from 5-Star that his Forza Italia party take no part in the next government.

“With Berlusconi out, an anti-establishment government is one step closer to reality and while both these parties may have their differences, they are united in at least one thing: more fiscal stimulus,” said Antoine Bouvet, a rates strategist at Mizuho in London.

Yields also rose at the short end of the Italian curve, with two-year bond yields rising 3 basis points to a two-month high at minus 0.13 percent.

The spread between two-year and 10-year bonds widened to a six-week high of 206 basis points.

Though a government led by 5-Star might not be the market’s ideal outcome, Morgan Stanley strategists said spreads should move higher only if there was a sharp pick-up in bond issuance to fund any fiscal stimulus plan.

Some investors, such as Charles Diebel, head of rates at Aviva Investors, said once enough yield premium is built in, Italian debt will remain a buy but it does not bode well for the European Union project.

ROBUST DEMAND

Apart from Italy, robust demand continued for peripheral debt. Data on Thursday showed Japanese investors bought a record 282.1 billion yen ($2.57 billion) of Spanish bonds in March as slim pickings in core European bonds and higher hedging costs for U.S. Treasury debt fuelled demand.

With the exception of Italy, most bond yields in the bloc fell on Thursday, dragged down by U.S. and British peers. Some European markets were closed for holidays.

In Britain, gilt yields fell after the Bank of England held interest rates steady and cut its growth and inflation forecasts.

U.S. Treasury yields also fell as a smaller-than-expected increase in the April consumer price index reduced fears that domestic inflation is picking up steam as the labor market tightens. (Reporting by Saikat Chatterjee; Additional reporting by Dhara Ranasinghe; Editing by Toby Chopra)

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