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Euro zone bonds sailing into weekend of risk events

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03/02/2018 | 05:26pm CEST
Presentation of a new 2 Euro commemorative coin in honour of former German Chancellor Helmut Schmidt

LONDON (Reuters) - Germany's 10-year government bond yield hit a five-week low on Friday, as an Italian election and a milestone in German coalition politics this Sunday together with worries about a global trade war boosted demand for safe-haven debt.

Italian bond yields fell to a three-week low, pushing the gap over German peers to its tightest in two weeks and suggesting some confidence among investors heading into Sunday's election.

U.S. President Donald Trump on Thursday announced plans for hefty tariffs on imported steel and aluminium to protect U.S. producers. That stoked concerns about a trade war, rattling stock markets and pushing U.S. and European bond yields down.

The worries sparked a broad sell-off in European stocks, weighing particularly on the export-oriented German DAX index, which fell 1.8 percent to a six-month low.

In the euro zone, the focus turned to two potentially major risk events this weekend.

On Sunday, Italians vote in an election that is expected to result in a hung parliament, with former prime minister Silvio Berlusconi's alliance of centre-right groups emerging as the largest bloc, while 5-Star looks certain to be the biggest single party.

Germany on Sunday gets the result of a ballot of Social Democrat (SPD) party members on a coalition deal with Chancellor Angela Merkel's conservatives, the outcome of which could seal or end Merkel's hopes for a fourth term in office.

"The base case we have is that we get through Italy with some sort of broad coalition that is market friendly, that Germany resolves its government situation and then there's two years where some of the larger European questions can be solved," said Mark Haefle, global chief investment officer at UBS Wealth Management.

Most euro zone bond yields were down 0-2 basis points.

Germany's benchmark 10-year Bund yield dropped to as low as 0.606 percent <DE10YT=RR> -its lowest level since late January- before inching up to 0.639 percent in late trades.

It has fallen almost 20 bps from more than two-year highs hit last month and is set for a fourth straight week of falls. Weak inflation data this week has helped reassure bond investors that an interest rate rise in the bloc remains some way off.

ELECTION, NO SWEAT

Italy's 10-year bond yield fell three bps to as low as 1.983 percent <IT10YT=RR>, its lowest level in 3 weeks. That pushed the gap over German peers to around 138 bps, also its tightest in almost two weeks. It rose back to 2.02 in late trades.

The spread - a key gauge of how investors view relative country risks in bond markets - has narrowed around 10 bps this week - a sign that investors are relatively comfortable holding Italian debt.

"Markets are more comfortable with political risk this time around compared with prior elections.. the political risks we've had over the past few years turned out to be quite benign," said Iacopo Dalu, a research analyst at Janus Henderson Investors.

"It is unlikely that we are going to wake up on Monday morning with a very bad outcome -- the tail risks are limited."

(This version of the story refiles to add graphic.)

(Reporting by Dhara Ranasinghe; additional reporting by Fanny Potkin Editing by XXX)

By Dhara Ranasinghe

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