May 9, 2018 / 10:37 AM / 7 months ago

UPDATE 2-Italian bonds lag on prospect of "populist" coalition

* Italy/Germany bond yield spread at widest in nearly six weeks

* Oil hits 3 1/2-year high after US exits Iran nuclear deal

* US 10-year Treasury yield moves above 3 pct

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Writes through)

By Abhinav Ramnarayan, Saikat Chatterjee and Dhara Ranasinghe

LONDON, May 9 (Reuters) - The gap between Italian and German borrowing costs reached its widest level in nearly six weeks on Wednesday on the possibility that a coalition of Italian anti-establishment parties would come into power.

The prospect of an Italian government composed of the 5-Star Movement and the far-right League is now looking increasingly likely after President Sergio Matarella effectively gave them 24 hours to form a coalition.

The Italy-Germany 10-year government bond yield spread widened 5 basis points after 5-Star and the League said they were holding last-minute talks to try to clinch a coalition deal and was wider 2 bps on the day.

The spread stretched to 132.7 basis points at one stage, its widest since March 29.,

It had already increased earlier in the week on the possibility of an early snap election, but the prospect of an anti-system government appeared to trump that worry.

“Snap elections may be avoided but we could now have a government of the two populist parties, with no moderating influence from an establishment party as part of government,” said ING strategist Benjamin Schroeder.

“But it’s still far from clear what the result will be.”

Italian 10-year bond yields rose two basis points to 1.88 percent.

Other euro zone government bond yields were either flat or lower on the day, with Germany’s 10-year bond yield, the benchmark for the region, unchanged at 0.56 percent.

It had risen earlier in the day as oil prices surged after U.S. President Donald Trump abandoned a nuclear deal with Iran and expectations for higher U.S. interest rates helped send Treasury yields to fresh highs.

U.S. bond yields initially fell after Trump’s announcement. But that drop was short-lived as expectations grew that the Fed would raise interest rates at least three more times this year, pushing U.S. bond yields to fresh highs in early European trade on Wednesday.

That sell-off dragged euro zone 10-year bond yields up 1 to 2 basis points, though the move proved short-lived.

Oil prices, meanwhile, rose more than 3 percent at one stage, hitting 3-1/2 year highs after the U.S. quit the Iran deal, adding upward pressure on euro zone bond yields. (Reporting by Dhara Ranasinghe and Saikat Chatterjee, editing by Larry King)

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