* German yields drop as Draghi tempers inflation outlook
* Spanish yields hit 1-year high on budget deal
* Recovery in risk appetite benefits Italian market
* IMF says Italy needs to respect EU budget rules
* Moody’s to review Portugal ratings
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Adds Spanish bond yield landmark, updates prices)
By Dhara Ranasinghe
LONDON, Oct 12 (Reuters) - German government bonds were set for their biggest weekly gain since August on Friday thanks to the equities rout and dovish comments on the inflation outlook from ECB chief Mario Draghi.
Draghi said on Friday that underlying inflation in the bloc would rise gradually, toning down earlier remarks which foreshadowed a “relatively vigorous” rise, helping push yields lower.
Having risen in early trade in response to a firmer tone in world stock markets, most high-grade bond yields in the euro zone crept back down to end lower on the day.
In Germany, the bloc’s benchmark bond issuer, 10-year yields were down two basis points at 0.50 percent and below 4-1/2-month highs reached earlier this week at 0.58 percent.
They are down about 6.5 bps this week, the first decline in six weeks and the biggest drop in two months.
While world stocks recovered some ground on Friday after this week’s rout, sentiment remained fragile. European shares were last up 0.5 percent and off their highs.
This biggest stock market shakeout since February has been blamed on a series of factors, including worries about the impact of a Sino-U.S. trade war, a spike in U.S. bond yields and caution before the earnings season.
“We’re still left with the sense that there has been a significant shift that markets now have to take stock of,” said Chris Scicluna, head of economic research at Daiwa Capital Markets in London.
For some analysts, the relatively small fall in German bond yields was a sign of investor reluctance to buy fixed income.
“Ten-year German yields failed to close through 0.50 percent in spite of the Italian budget turmoil at the start of the week, and despite the global stocks meltdown,” Mizuho analysts said in a note.
Italy’s bonds stabilised, with two-year yields edging 2 bps lower and 10-year yields flat on the day as risk appetite recovered.
Analysts said a lot of negative news has now been priced into the market.
Italian 10-year bond yields rose to 4 1/2-year highs earlier this week on tension between Rome and the European Union over the government’s expansionary budget plans.
The International Monetary Fund said on Friday that Italy needs to respect EU budget rules and build a cash buffer for the next economic downturn.
Portugal was also in focus amid expectations that ratings agency Moody’s would lift its rating by one notch later on Friday.
“It’s our base case that Portugal will be upgraded to investment grade, it is overdue,” said Michael Leister, rates strategist at Commerzbank.
The other major Southern European nation, Spain, saw its 10-year government bond yield hit its highest point in a year with two analysts citing the minority government’s planned budget measures as a driver.
Sunday’s election in the German state of Bavaria was also in focus. Chancellor Angela Merkel’s Bavarian allies are heading for their worst showing in a state election in over 60 years, a setback that risks widening divisions within her crisis-prone national government.
Reporting by Dhara Ranasinghe, editing by David Stamp and Susan Fenton