* Chinese, euro zone factory PMIs fuel gloomy outlook
* German 10-year yields drop to as low as 0.148 pct
* Bund yields set for biggest daily drop since Sept 2016
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates pricing, adds quote, detail on Spanish bond sale)
By Abhinav Ramnarayan
LONDON, Jan 2 (Reuters) - Benchmark German government bond yields were set for their biggest one-day fall since September 2016 after business surveys in China and the euro zone underlined worries about the global growth outlook and hit stock markets.
China saw factory activity contracting for the first time in over two years, sending mainland Chinese shares 1.4 percent lower and weighing on the S&P 500.
The gloom continued in Europe, where Purchasing Managers’ surveys for the euro zone were at their lowest since Feb. 2016 and future output PMIs were at a six-year low.
German Bunds are seen as one of safest and most liquid assets in the world, and tend to rally at times of stress.
The yield on Germany’s 10-year government debt - which moves inversely to price - dropped as low as 0.148 percent, its lowest since November 2016, and down over nine basis points on the day.
“This drop in Bund yields is a reflection of a weakness in equities and overall risk sentiment,” Commerzbank rates strategist Rainer Guntermann said. “China is one of the main drivers, with the PMIs today showing manufacturing in contraction, and the Chinese equity markets as well being hit.”
The gap between German 2-year and 10-year bond yields was its tightest since November 2016 at 78.5 basis points.
U.S. 10-year Treasury yields briefly fell to their lowest since early February at 2.647 percent.
Money market prices indicated that investors are now only pricing in less than a 30 percent chance of a rate hike from the European Central Bank in 2019.
Italy provided some relief in an otherwise gloomy start to 2019, with the country’s 10-year yields touching their lowest level since July 2018 after lawmakers in Rome endorsed the government’s 2019 budget late last year.
Parliament on Saturday passed the budget, just meeting an end-year deadline following a deal last week with the European Commission that calmed financial markets and averted the risk of fines against Rome.
With bond futures trading for the first time since then, Italian yields dropped 5-9 basis points across the curve.
“It is one of the few places investors find positive returns, which explains why Italy has kept pace with the rally in Bunds,” said Richard McGuire, rates strategist at Rabobank
The yield on Italy’s 10-year government bond dipped as much as 11 bps to 2.672 percent, the lowest since July 25.
The Italy/Germany 10-year bond yield spread tightened to as narrow as 238 basis points, before widening to around 251 basis points, not as dramatic a move as German yields were compressed by concerns over global stock markets and the economic outlook.
Spanish bonds by contrast have not performed as strongly as German and Italian government paper. Spain’s 10-year government bond yield fell only 1.6 basis points on the day to 1.41 percent .
McGuire said the expectation of further supply from Spain on Thursday, as well as some concerns over the passage of the Spanish budget, could be to blame.
Spain plans to sell 4-5 billion euros of bonds maturing 2021, 2023 and 2028, as well as 0.25 - 0.75 billion euros of inflation linked bonds at auction on Thursday.
Reporting by Abhinav Ramnarayan; additional reporting by Virginia Furness Editing by Saikat Chatterjee and Mark Heinrich