October 31, 2017 / 8:44 AM / a year ago

UPDATE 3-Strongest month for Italian government bonds since July 2015

* Italian 10-year bond yields fall 34 bps in Oct

* Sentiment boosted by ratings upgrade, ECB policy

* Spanish yields record biggest monthly drop of 2017

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

By Dhara Ranasinghe

LONDON, Oct 31 (Reuters) - Italian government bond yields recorded their biggest monthly fall in over two years in October on the back of a surprise ratings upgrade, the extension of the ECB’s ultra-easy monetary policy and the approval of a new electoral system.

Most euro zone bond yields flat-lined after data showed the euro zone economy grew faster than expected in the third quarter and unemployment fell to an almost nine-year low. Consumer inflation, however, slowed in October to 1.4 percent after two months of faster rises.

In contrast to their peers, Italian and Spanish bond yields hit fresh lows after a run of eye-popping moves in recent days.

Italy’s benchmark 10-year bond yield fell 2 basis points to a 10-month low at 1.82 percent on Tuesday, leaving with a 34 basis-point fall in October - its best performance since July 2015.

That comes against a backdrop of recent positive news for Italy, the region’s third-biggest economy.

Worries about a coming national election have been eased by the Italian parliament’s approval of a new electoral system that is expected to handicap the anti-establishment 5-Star Movement and favour mainstream political blocs.

In addition, the European Central Bank said last week it would extend its bond-buying scheme well into next year, albeit at a reduced amount.

Italy, a key beneficiary of the ECB scheme, got another lift when Standard & Poor’s unexpectedly raised its sovereign rating for Italy to BBB on Friday, its first such increase for Italy in at least three decades.

“The ECB provided the necessary backdrop, while the electoral law is important for the long-term outlook because election risk was always looming in the background for many people,” said ING senior rates strategist Benjamin Schroeder. “And the ratings upgrade was the cherry on top.”

Sentiment was also underpinned by easing worries about Spain as it became clear on Monday that there would be little resistance in Catalonia after the central government reasserted its control over official institutions in the region, which has pushed for independence.

Catalonia’s ousted leader Carles Puigdemont on Tuesday agreed to the snap election called by Spain’s central government for December.

Spanish bond yields fell to their lowest level in six weeks on Tuesday at 1.46 percent. They fell 15 bps in October, their biggest monthly fall of the year.

Analysts said stability in the outlook for peripheral bond markets had encouraged carry trades, where investors borrow in low-yielding assets to invest in higher yielding ones.

“The relatively sanguine mood in bond markets is supportive for carry trades,” said Kim Liu, senior fixed income strategist at ABN AMRO.

The sharp fall in peripheral bond yields this month contrasts with a fall of about 10 bps in top-rated German 10-year bond yields. That has left the gap between Italian and German bond yields at 146 bps, its lowest levels since October 2016. The Spanish/German yield spread is at its tightest in around five weeks.

Reporting by Dhara Ranasinghe; Editing by Raissa Kasolowsky

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