* US/German two-year yield gap hits 300 bps
* Fed rate-hike bets, softer euro zone data push out spread
* Peripheral bond yields fall again
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices)
By Dhara Ranasinghe
LONDON, April 18 (Reuters) - The gap between short-dated U.S. and German borrowing costs reached its widest in almost three decades on Wednesday, reflecting a growing divergence in interest rate outlooks for the U.S. and European central banks.
New signs of subdued inflationary pressure in the euro zone bolstered expectations of a cautious stance from the European Central Bank.
Portugal’s 10-year bond yield fell to a three-year low. Italian yields hit their lowest level this year.
Euro zone inflation rose 1.3 percent in March, compared with the same period last year, down from a previous estimate of 1.4 percent, data showed.
On Tuesday, Germany’s ZEW research institute said its index of investor morale fell to its lowest in more than five years in April, pushing bond yields down as investors bet a rate rise from the ECB could come later rather than sooner.
Germany’s 10-year bond yield, the benchmark for the bloc, was up 2 basis points on the day at 0.531 percent in late trades .
Bonds also got support from UK data, which showed inflation at a one-year low in March, raising some doubts over whether the Bank of England will raise interest rates in May. In contrast, U.S. data this week has reinforced expectations for more rate increases from the Federal Reserve this year.
The U.S. two-year Treasury yield rose to 2.431 percent on Wednesday, a new decade high. That pushed the gap over German peers to 300 basis points (bps) - the widest since 1989.
“Ninety-nine percent of the spread widening is down to the divergence of central bank polices,” Mizuho rates strategist Antoine Bouvet said. “The market has recently regained optimism that the Fed could tighten policy, driving 2-year U.S. yields higher.”
In Europe, 10-year bonds yields fell 0.5 to 4 bps, once again led by southern Europe.
Spanish, Italian and Portuguese yields continue to drop amid relatively strong economic conditions, confidence that ECB monetary tightening remains some way off and good news from the region’s banks.
Portugal’s 10-year bond yield fell to a three-year low at 1.59 percent. Italian yields hit their lowest since late 2017 at 1.713.
The premium that investors pay to hold Italian 10-year bonds over top-rated Germany was at 118.4 basis points, its tightest since February.
The ECB meets next week and is not expected to make any major changes. Markets don’t foresee any change in interest rates until mid-2018.
“There is a feeling that there is no rush for central banks to either accelerate the removal of stimulus or hasten the pace of tightening, and that is supportive for the likes of the periphery,” Credit Agricole European fixed income strategist Orlando Green said.
Germany sold about 2.5 billion euros of 10-year bonds.
Reporting by Dhara Ranasinghe, editing by Larry King