* German debt rallies on as ECB spurs depo rate cut bets
* Italian political flare-up drives peripheral selloff
* Italy off session highs as yield rise brings buyers back
By William James
LONDON, Dec 6 (Reuters) - German bonds rallied and two-year yields hit their lowest in three weeks on Thursday after ECB President Mario Draghi said the bank had discussed cutting the rate on short-term deposits below zero.
The European Central bank left interest rates on hold but grim growth forecasts, sharply downgraded since September, and signs that a deposit rate cut was still a policy option helped yields fall across the German yield curve.
Draghi’s comments added momentum to a shift into low-risk assets that had hit Italian bonds hard during the morning session after domestic political tension undermined the position of Italy’s technocrat Prime Minister Mario Monti.
“What Draghi said reinforced the risk-off environment we’d seen in the morning after the negative news on Italy,” said Christian Lenk strategist at DZ Bank in Frankfurt.
Two-year German yields, which are most sensitive on the curve to a shift in monetary policy, sank close to their record lows, dropping 4.7 basis points to -5 bps.
The March 2013 Bund future, which became the front-month contract during the session, rallied more than half a point to 145.72, picking up steam after breaking past technical resistance at November’s peaks to set a new contract high.
Italian bonds led a broad peripheral selloff after former Prime Minister Silvio Berlusconi’s PDL party walked out on a Senate confidence vote, ratcheting up the party’s opposition to the incumbent Monti before an election due early next year.
“These kind of hiccups and the weakening of the technocrat government is clearly affecting market valuations. To a big extent things are still OK, but that was clearly a reminder that these types of events are super important,” said David Schnautz, strategist at Commerzbank in New York.
The 10-year Italian yield rose by as much as 17 basis points on the day to a high of 4.63 percent before coming back to 4.56 percent as the selloff drew more optimistic buyers back in. Equivalent Spanish yields followed a similar path and ended the day 4.5 bps higher at 5.47 percent.
Traders said the extent of the selloff had been exaggerated by speculative investors using the political backdrop as an excuse to exit profitable positions after a big rally in the last week.
However, the subsequent retracement underscored both the impaired liquidity in the market and the general positive outlook on higher-yielding debt supported by the prospect of ECB purchases.
“At these levels some buyers return. Our view is still basically to buy the dips at the short end of the periphery,” DZ Bank’s Lenk said. “You still get good bang for the buck there, so why not use these levels to add to you positions?”
The risk-averse backdrop helped a 3.97 billion euro sale of French bonds. The Treasury sold at the top of its target range as investors sought the liquidity and safety of the French market, even after Moody’s downgraded the euro zone’s second-largest economy’s credit rating last month.