UPDATE 2-Italian debt set for second best week since 2019

(Adds analyst, Centeno comment, updates prices)

By Yoruk Bahceli and Dhara Ranasinghe

May 13 (Reuters) - Euro zone bond yields rose back on Friday but were set for big weekly falls as a darkening economic outlook dented rate-hike expectations.

Yields in Italian debt, in particular, saw its second biggest drop since 2019.

Borrowing costs across the bloc have surged this year as investors braced for a series of rate hikes from the European Central Bank to contain inflation.

But battered bond markets have seen a remarkable turnaround this week as growth fears resurfaced, knocking equity markets and renewing demand for safe-haven bonds.

That also prompted investors to cover positions on bond prices falling further, and yields rising.

In the euro zone, yields on Italian debt, among the key beneficiaries of ECB stimulus, have dropped the most.

On Friday, 10-year yields were up 14 basis points (bps) at 2.86% in what has been a volatile week of trade, still well below a more than three-year high of 3.23% hit on Monday.

Down 29 bps this week, they were set for their second best weekly performance since August 2019.

The closely watched premium over German 10-year yields fell to 190 bps, from over 205 bps earlier in the week, which had been the highest since May 2020.

"That's mainly a positioning led move and people getting caught a bit short with widening being quite the consensus trade," said Peter McCallum, rates strategist at Mizuho.

"When we speak with clients, (Italy) is still a major concern with them, especially with the ECB ending net (asset purchases) and what comes next. I think people are cautious about what could happen," McCallum added.

A survey conducted by BofA showed that investors remained cautious when it comes to investing in Italian debt.

"They either do not intend to buy BTPS at all or until they are much cheaper," the bank's analysts commented in a research note.

The moves in Italian debt came as worries on economic growth prompted investors to reduce their bets on ECB rate hikes this year, with money markets now pricing in around 81 bps of hikes by year-end, compared with 95 bps at the start of the week.

But with inflation soaring to a record high of 7.5% in the euro zone last month, several ECB policymakers are still advocating for a hike in July. On Friday, governing council member Mario Centeno said the interest rate hike cycle should begin in early July.

Germany's 10-year yield, the bloc's benchmark, is down 18 bps this week, set for its best weekly performance since the first week of March. The bonds went back higher on Friday at 0.96% and are still up 113 bps in the year so far.

"The market deserves a break after having tripled in yield, when they went from around -0.5% to 1%," said Nick Hayes, head of sterling rates and credit at AXA IM, London, referring to the Bund yields.

(Reporting by Yoruk Bahceli and Dhara Ranasinghe; additional reporting by Julien Ponthus Editing by Kim Coghill, Hugh Lawson and Alison Williams)