June 4, 2018 / 10:47 AM / in 17 days

UPDATE 2-Southern Europe's bond rally gathers pace as Italy worries ebb

* Italy/German bond yield spread at tightest in a week

* Markets calm after last week’s ructions

* Southern Europe outperforms

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

By Dhara Ranasinghe

LONDON, June 4 (Reuters) - A rally in southern European bond markets gathered pace on Monday as investors took comfort from the creation of a government in Rome that ended months of political turmoil and a relatively smooth handover of power in Spain.

The gap between 10-year Italian and German government bond yields - a closely watched indicator of relative risks - narrowed to 211 basis points.

That is its tightest in a week, just before it blew out to more than 300 bps on fears about the possibility of a new election becoming a de facto referendum on Italy’s euro membership.

But new Italian Economy Minister Giovanni Tria said late on Friday that none of the country’s parties wanted to leave the euro zone and neither did he.

And while the two anti-establishment parties that make up Italy’s new government are set on big spending plans that are likely to put upward pressure on borrowing cost longer-term, stability in Rome has bought some calm to markets for now.

“We have more clarity and now it’s up to investors to assess the risk outlook,” said Commerzbank rates strategist Rainer Guntermann. “There is a bit more relief.”

Italy’s 2-year bond yield was down 27 basis points to 0.76 percent, having briefly surged last week to 5-year highs around 2.7 percent. Italian 10-year bond yields were down 21 bps at 2.53 percent.

“The stalemate has ended, but volatility is here to stay – both in statements and in markets – as untested political leaders start taking action,” Marco Valli, chief European economist at Unicredit told clients.

“The budget law will be crucial to understand where we are heading.”

Spanish socialist Pedro Sanchez meanwhile took over as prime minister on Friday from veteran conservative Mariano Rajoy, who lost a no-confidence vote in the wake of a corruption scandal.

While Sanchez will head a minority government at a time when an independence campaign in Catalonia is gathering pace again, the relatively smooth handover of power eased market concerns of further disruption in southern Europe.

Portugal’s 10-year bond yield fell to a three-week low at 1.71 percent, before settling at 1.76 percent, while Spanish bond yields were down 11 bps at 1.34 percent .

As turmoil in Italy eased, investor expectations for a June 2019 European Central Bank rate rise also picked up, with markets pricing in a 50 percent chance of a move then, having put the possibility at roughly 30 percent last week.

Analysts said comments from German Chancellor Angela Merkel at the weekend helped support sentiment towards peripheral bonds.

Merkel ruled out debt relief for Italy but she also offered her most detailed response to French President Emmanuel Macron’s ideas for reforming Europe, seeking to avert a rift with Paris at a time of high anxiety over Italy and growing transatlantic tensions.

Slovenian bond yields rose after a right-wing opposition party won the most votes in a parliamentary election on Sunday, but not enough to form a government on its own.

Germany’s 10-year bond yield meanwhile was up 4 bps at 0.42 percent, also facing upward pressure from higher U.S. Treasury yields.

U.S. yields rose on Friday after data showed the world’s largest economy created more jobs than expected in May, fuelling expectations that the Federal Reserve could increase the pace of interest rate rises this year.

Reporting by Dhara Ranasinghe; Editing by John Stonestreet and Andrew Heavens

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