* Euro zone bond yields drop 4-5 bps on safety bid
* Wall St sell-off sets challenging backdrop for Italy auction
* Italy/Germany spreads widens, back above 300 bps
* U.S. inflation data due out at 1230 GMT (Updates with US data, ECB minutes)
By Abhinav Ramnarayan
LONDON, Oct 11 (Reuters) - Investors retreated to the safety of German government bonds on Thursday, pushing down yields, as the effects of a sharp selloff on Wall Street made themselves felt across the world.
This set an uncomfortable backdrop for a key Italian auction, but the country’s debt agency squeezed through a 6.5 billion euro bond sale, pulling yields off the day’s highs.
U.S. stocks tumbled on Wednesday, with the S&P 500 and the Dow marking their biggest daily declines since Feb. 8, prompting U.S. President Donald Trump to criticise the Federal Reserve.
That sparked a flight to safety bid and the yield on better-rated euro zone government bonds — which move inversely to price — fell two to four basis points.
Yields on 10-year German government bonds, seen as one of the safest and most liquid assets in the world, fell as much as six basis points to a one-week low of 0.49 percent before settling at around 0.52 percent.
U.S. Treasury yields also fell to one-week lows on Thursday, with a weaker-than-expected rise in U.S. inflation for September adding to the bullish tone in bond markets.
“It remains to be seen whether the accelerating equity plunge is a healthy correction or the tip of the iceberg,” Commerzbank analysts said in a note. They said it created a challenging environment for the Italian auction.
However, Italy sold a maximum 6.5 billion euros of bonds with demand exceeding supply by a comfortable margin for all of the bonds on offer, though yields were expectedly far higher than in the previous auction.
“It was a fairly mixed result, with strong demand for three of the four bonds,” said Mizuho strategist Antoine Bouvet.
“Overall it’s not enough for the market to continue selling off, pending any other developments we may even see a short-term bounce,” he said.
Italian yields had risen sharply across the curve ahead of the auction but came off the day’s highs after the debt sale.
Italy’s two-year bond yield was last up 10 bps at 1.79 percent but off session highs at 1.85 percent.
Benchmark 10-year yields were also off the day’s highs, trading at 3.57 percent and the spread over Germany eased to 305 bps from 310 bps earlier.
Most Italian yields are trading near four-year highs after the new anti-establishment government’s spending plans put the country on a collision course with the European Union and raised questions over the sustainability of public finances.
“The key issue for Italy is debt sustainability, so that’s why the results of the auction are important,” said Arnaud-Guilhem Lamy, a portfolio manager at BNP Paribas Asset Management.
Bond markets meanwhile showed little immediate reaction to the policy minutes from the European Central Bank’s last meeting.
Global trade tensions could slow euro zone growth further and ECB policymakers debated whether to downgrade their risk assessment, the minutes of their September meeting showed on Thursday. (Reporting by Abhinav Ramnarayan Editing by Raissa Kasolowsky and Jon Boyle)