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UPDATE 2-Italian bond yields set for huge monthly drop as rally extends

By Yoruk Bahceli

* Euro zone flash inflation at 1% in August

* Italian bonds outperform rivals with huge rally

* Portuguese yields see record 10th monthly decline

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Adds details, updates latest prices)

By Yoruk Bahceli

LONDON, Aug 30 (Reuters) - Italian bond yields rose on Friday but were heading for one of their biggest monthly declines in more than six years, reflecting a fall in the political risk premium on the country's debt amid growing expectations of European Central Bank stimulus.

Euro zone bond markets in general were set to end August with further significant declines in yields. Portuguese yields were on track for a 10th straight month of falls and German yields for their biggest since 2016.

Italy's bond market was one of the bloc's best performers as investors grabbed its positive-yielding debt and the 5-star Movement and Democratic Party reached an agreement on a new governing coalition. The 10-year yield has dropped some 51 basis points in August for a third consecutive month of falls.

The 50-year Italian yield down 53 bps, the biggest decline since it was first offered in late 2016.

Italian yields did rise on Friday, however. The 10-year yield was up 5 bps at 1.036% after 5-Star leader Luigi Di Maio said it would only enter a coalition if the Democratic Party agreed to a string of policy demands.

The market "didn't like his words, as they show a new government in Italy is not yet 100% guaranteed... The scenario of new elections basically remains in the background," said a Milan-based trader.

The market has already priced in a new government that can set the 2020 budget and run into 2020, said Antoine Bouvet, senior rates strategist at ING, making the rally vulnerable to any disappointing news.

Notwithstanding Friday's move, Italian bond prices have soared this week, part of a broad rush into the safety of euro zone government debt.

"You have a background of a slowing euro economy with no progress on the inflation front, an increase in global risks, partly due to the U.S.-China trade tensions," said John Davies, G10 rates strategist at Standard Chartered.

"The upshot of all of that is an ECB that is expected to ease policy further, at least by cutting rates, but the extent of the rally into the periphery tells you that the market is pinning its hopes on a renewed quantitative easing programme."

Portugal's 10-year bond yield, down 23 bps in August, is set for a 10th month of falls - its longest streak of monthly falls on record, according to Refinitiv data.

Safe-haven Germany's 10-year yield dropped 2 basis points to -0.70%, close to record lows. It was set for its biggest monthly decline since June 2016, when Britain's decision to leave the European Union rattled world markets.

Euro zone inflation remained low at 1.0% in August, below the ECB's target, a first estimate showed on Friday, reinforcing market expectations of monetary stimulus in September - though executive board member Sabine Lautenschlaeger said it was too early to consider a "huge" stimulus package

U.S. inflation data is due later on Friday.

(Reporting by Yoruk Bahceli; additional reporting by Dhara Ranasinghe, Tommy Wilkes and Giulio Piovaccari in Milan; Editing by Larry King and John Stonestreet)