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Italy/German yield gap at 2017 lows as ECB steps up Italy bond buys

* ECB bought more Italian debt than supposed to in July

* Central bank bond-buying, carry trades support BTPs

* BTP/Bund spread at lowest level in 2017

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

By Dhara Ranasinghe

LONDON, Aug 8 (Reuters) - Italy's 10-year bond yield touched a six-week low on Tuesday, closing the gap over top-rated German peers to its tightest this year following signs of outsized buying of Italian debt by the European Central Bank.

Data released late on Monday showed the ECB bought far more Italian bonds than it was supposed to in July for its monetary stimulus scheme, making up for a dwindling supply of eligible debt elsewhere in the currency bloc.

The ECB and Bank of Italy together bought 9.6 billion euros of Italian debt, nearly one and a half billion more than the composition of the 60-billion euros monthly purchase would dictate.

This was the biggest deviation from Italy's quota relative to the size of the overall monthly amount.

"It is interesting that we see a persistent deviation of the ECB's capital key target and that it bought more Italian bonds than it should. Relatively this is supportive for BTPs," said Martin van Vliet, senior rates strategist at ING.

Italy's 10-year bond yield briefly hit a six-week low at 1.97 percent, leaving the gap over benchmark German Bund yields at its lowest this year at just under 152 basis points.

The gap has tightened about 25 bps in the past month, reflecting strong demand for Italian debt that has also been driven by carry trades, where investors borrow in low-yielding assets to invest in higher-yielding ones such as lower-rated euro zone bonds.

French and Spanish bond purchases by the ECB were also oversized in July compared to their shares of the ECB's capital, the yardstick used to determine how many bonds must be bought.

This may help explain why peripheral bond markets held up relatively well during a sell-off that followed comments by ECB chief Mario Draghi in Sintra, Portugal in late June.

His remarks were widely viewed as presaging a shift in the ECB's ultra-loose monetary policy stance in coming months.

Bank of America Merrill Lynch said in a note that a rise in the share of Italian bond purchases by the ECB in July and the average maturity of Italian bonds bought suggested the Bank of Italy might have used the flexibility of the asset-purchase scheme to contain the selloff in BTPs in early July.

Italian bonds have recovered most of the losses made in the wake of Draghi's Sintra speech, with yields roughly 10 bps above where they traded the day before the comments. In contrast, German Bund yields are about 21 bps higher.

Across the euro zone, bond yields were up slightly on Tuesday.

Ten-year Bund yields rose around 2 basis points to 0.48 percent -- but did not stray far from last week's one-month lows after data showed German exports fell more than expected in June.

Elsewhere, Austria sold 1 billion euros of government bonds at an auction.

(Reporting by Dhara Ranasinghe; editing by John Stonestreet and Pritha Sarkar)

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