* Italy’s seven-year yields hit 20-month low at auction
* U.S. udnerlying inflation firmer, Treasury yields rise
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Adds bond price moves on higher-than-expected U.S. inflation)
By Dhara Ranasinghe and Abhinav Ramnarayan
LONDON, July 11 (Reuters) - Italy’s borrowing costs dipped and the spread over Germany tightened on Thursday after an auction of short- and medium-term government bonds showed further evidence of strong demand for higher-yielding Italian debt.
Italy paid the cheapest seven-year yields in 20 months at the auction, thanks to demand from investors hunting for returns amid a sharp erosion in euro government yields - over half of which are below zero.
A sale of three-year Italian bonds was placed at 0.49%, more than halved compared with 1.05% at the previous auction in mid-June and the lowest since May 2018.
Thursday’s bond sales follow a re-opening of a 50-year Italian bond for 3 billion euros on Tuesday that drew bids for more than five times that amount.
“Investors are still keen on a bit more buying in Italy despite the strong rally we’ve seen,” said Natixis fixed income strategist Cyril Regnat. “When you look at how negative yields are on core government bond issuers, it makes sense to keep buying Italian bonds.”
Italian yields fell 2 to 5 basis points across the curve , while most other euro zone bond yields were higher on the day.
Italy’s 10-year bond yield fell 2 bps to 1.71%, pushing the gap over German Bund yields back below 200 bps, ending the day at 197 bps.
Italy last week dodged the threat of EU disciplinary action over its public finances after persuading the European Commission that new measures would help bring its growing debt into line with EU fiscal rules.
The country’s bond market has also benefited from speculation the European Central Bank may soon begin new asset purchases to boost weak growth and inflation.
That backdrop has proved favourable for this week’s bond sales.
Almost half way into July, Italy’s 10-year bond yield is down some 40 basis points, compared with a 3 bps rise in Germany and a 2 bps decline in French yields.
“We have added exposure to Italian BTPs, which was a move driven by heightened expectations of QE being announced, for which Italian sovereign bonds have historically been a key beneficiary, and at a time when imminent EDP (excessive deficit procedure) risks on Italy have faded,” said Mohammed Kazmi, a portfolio manager at UBP.
Most other euro zone bond yields rose, tracking U.S. Treasuries higher, after data showed underlying inflation in the United States increased by the most in nearly 1-1/2 years in June.
The move added to the conviction that perhaps the economic outlook is not as bad as feared, with data on Wednesday showing French industrial output rose 2.1% in May, its biggest monthly increase since November 2016.
German 10-year bond yields closed the day 4 basis points higher at -0.26%, having posted its biggest one-day jump since April the day before. It is about 14 bps above last week’s record lows.
Other euro zone yields were about 2-5 bps higher on the day.
Reporting by Dhara Ranasinghe; Editing by Alison Williams, Larry King and William Maclean