February 14, 2018 / 12:27 PM / 6 months ago

UPDATE 1-South European debt in demand as strong economy returns to spotlight

* Italian and Portuguese bonds outperform market

* Euro zone GDP growth highest in a decade in 2017

* Core yields lower ahead of U.S. inflation numbers

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Rewrites throughout)

By Abhinav Ramnarayan

LONDON, Feb 14 (Reuters) - Southern European government bonds were in demand on Wednesday as euro zone economic data brought comfort to investors shaken in recent days by political concerns.

Italian and Portuguese bond yields dropped 2-5 basis points on the day, outpacing better-rated peers as data showed growth in the bloc was the highest in a decade in 2017.

Portugal sold 1.25 billion euros of 5-year and 10-year bonds in an auction after data showed its economy grew at its fastest pace in 17 years.

The country’s debt was the strongest performer of the day, dropping 5 basis points to 2.07 percent.

Italian numbers, despite being slightly more subdued than expected by analysts, looked to have helped sentiment towards a country that is due to hold a general election in less than a month, with eurosceptic parties likely to be part of a new government.

Italy’s 10-year government bond yield was 2 bps lower at 2.06 percent, and the spread over euro zone benchmark Germany narrowed to 132 bps.

That spread had widened 17 bps in the past week amid the potential collapse of a German coalition deal that investors believed would have favoured Southern European countries.

Concerns over the strength of support for eurosceptic parties in Italy ahead of the March 4 election may have also contributed.

The Northern League, a partner in the coalition expected to win the vote, would aim to pull Italy out of the European Union if Brussels refused to re-negotiate fiscal and immigration rules, its economics chief said.

As the session progresses, U.S. inflation numbers are likely to be the main driver, particularly among better-rated bonds.

Across the developed world, strong economic growth has so far had little impact on inflation, making it harder for central banks to tighten policy.

“Markets have priced in rate hikes by the Fed and change in guidance by the ECB all based on the assumption we will have a shift towards higher inflation,” said DZ Bank strategist Daniel Lenz.

“...We cannot be sure this is a trend yet - but the market will react if we see some evidence of that in today’s data.”

Germany’s 10-year government bond yield was down 1 bps to 0.74 percent ahead of the U.S. data release, dropping further away from multi-year highs of 0.81 percent hit last week.

The yield on the 30-year Bund rose 1 bps to 1.39 percent, after Germany sold 1.273 billion euros in a top-up of its 2.50 percent, 30-year bond. (Reporting by Abhinav Ramnarayan; Editing by Alison Williams and John Stonestreet)

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