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UPDATE 4-Italy leads euro zone bond selloff on ECB unease, politics

·3 min read

* Italian 10-year yields rise to over 8-month high

* French 10-yr yields top 0.3% for first time since March 2020

* Spain, Portugal yields at highest in almost a year

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

By Dhara Ranasinghe

LONDON, May 17 (Reuters) - Italian borrowing costs rose on Monday to the highest in over eight months, leading a selloff across the euro zone on concerns over Italy's reform path and the possibility that the ECB might slow the pace of its bond-buying stimulus in coming months.

Investors are increasingly pricing the possibility that economic recovery, fuelled by rapid COVID-19 vaccine rollouts, could encourage the European Central Bank to slow the pace of its emergency PEPP bond purchases.

Italy, a big beneficiary of ECB asset purchases, bore the brunt of selling. Its 10-year yields were up four basis points (bps) to 1.113% by 1519 GMT after rising as much as six bps earlier in the day.

That was on top of a 16 bps increase last week, while the gap over German peers widened to late-2020 levels and was last at 122.27 bps.

Selling was exacerbated by weekend comments from Matteo Salvini, leader of Italy's right-wing League party, that Prime Minister Mario Draghi will be unable to enact key reforms demanded by the European Union because his unity government is too divided.

The selloff spread across the bloc, with France's 10-year yield briefly topping 0.3% for the first time since March 2020. German yields rose around 1 bps to -0.114%, heading towards the near two-year peaks hit last week.

"The euro zone government bond market is generally in bad shape, especially for longer-dated pick-up paper, with France and SSAs (Sovereign Supranational Agency bonds) suffering as well, and Bunds," said Commerzbank rates strategist Christoph Rieger.

Pick-up refers to spread available on riskier debt compared with regional benchmark Germany.

"Talk of less ECB buying certainly fits the picture. And perhaps the Salvini headlines over the weekend also added to the widening today as investors are getting nervous about what happens after 2023 if fiscal front-loading is not paying higher growth dividends in coming years."

Saxo Bank strategist Althea Spinozzi said news Hungary's central bank could soon consider lifting interest rates may have fed unease too.

"Peripheral bond yields are so low, they would be the first to re-price if there's concern about ECB tapering or rate hikes," Spinozzi said.

Portuguese and Spanish 10-year yields rose to their highest in almost a year, and were last up around 2 bps and 3 bps respectively .

So far, higher bond yields have not caused alarm, possibly as markets and ECB officials see the stronger economic backdrop as justifying a re-pricing.

Views differ within the ECB board on the future pace of emergency bond purchases, Pictet Wealth Management strategist Frederik Ducrozet noted, adding the ECB "would find it difficult to materially reduce the pace of PEPP purchases at the June meeting".

(Reporting by Dhara Ranasinghe; Additional reporting by Danilo Masoni and Sujata Rao; Editing by Alison Williams and Steve Orlofsky)