February 4, 2019 / 11:03 AM / in 4 months

UPDATE 2-Italy's bond yields test three-week highs on economy worries

* Italy bonds underperform, yields at almost three-week high

* Other euro zone bond yields largely flat

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

By Dhara Ranasinghe

LONDON, Feb 4 (Reuters) - Italy’s government borrowing costs briefly rose to their highest level in three weeks on Monday, pushed up by heightened concern that a deteriorating economic outlook will worsen the country’s fiscal position.

While yields drifted lower as the session wore on, analysts said that was caused more by a lack of fresh drivers than a change in the bearish tone that gripped markets at the end of last week.

Data last week confirmed Italy’s economy had slipped into a recession in the fourth quarter of 2018, while manufacturing contracted for the fourth month running in January — suggesting that things could get worse for the economy.

Weaker data in general has bolstered euro zone bond markets as investors bet the European Central Bank will keep record-low rates in place for longer.

But in Italy, the poor data has only exacerbated concern about a further deterioration in public finances and fuelled speculation about further budget measures. Italy is one of the most indebted countries in the euro area.

“The scepticism that we saw last year about the wisdom of the new government’s fiscal plans is being revived by the economic data,” said Chris Scicluna, head of economic research at Daiwa Capital Markets in London.

“There is a decent chance that we will see another quarter of negative growth in Q1.”

Daiwa expects the Italian economy to grow just 0.1 percent in 2019. Last month, the Bank of Italy cut its 2019 economic growth forecast to 0.6 percent from 1 percent.

Italy’s 10-year yield rose almost eight basis points to 2.806 percent before drifting lower to around 2.75 percent, up about 2 basis points on the day.

After a heavy selloff, bonds across the curve found more stable ground, with two- and five-year yields also up about 1-3 bps .

They remained within sight of three-week highs and analysts said the pain for Italy’s bond market was not over yet.

“Italy has a huge debt burden and they (the government) had hoped for better growth,” said Michael Hewson, chief markets analyst at CMC Markets. “At some point this year, Italy will flare up as a problem once more.”

Outside Italy, yields on most 10-year bonds in the bloc were a touch higher on the day. Germany’s 10-year Bund yield, at 0.18 percent, held near recent one-month lows.

Reporting by Dhara Ranasinghe, editing by Larry King and Gareth Jones

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