UPDATE 3-Italy’s bond yields hit seven-week low, Bund yields at one-month high

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* Italy/German Bund yield gap below 200 bps

* Italian 10-year yields lowest in almost seven weeks

* (Adds ECB exclusive story, updates prices)

By Dhara Ranasinghe

LONDON, May 26 (Reuters) – Italy’s 10-year bond yield fell to a seven-week low on Tuesday as risk assets rallied and comments from a European Central Bank official boosted hopes of further stimulus soon.

Italian borrowing costs have fallen for seven straight days, pushed down after a Franco-German proposal a week ago for a 500- billion-euro recovery fund that would offer grants to those European Union regions hit hardest by the coronavirus pandemic.

The latest rise in prices pushed 10-year yields as low as 1.53% at one stage and came as world stocks rallied on hopes for a swift global economic recovery. The yield was set to close the day at 1.55%.

Comments from ECB policymaker Francois Villeroy de Galhau boosted expectations of fresh stimulus at next week’s ECB meeting.

As 10-year Italian bond yields declined to their lowest in seven weeks, the gap over top-rated German Bund yields fell below 200 basis points for the first time since mid-April .

The cost of insuring Italian bonds against a default also fell.

“The positivity from the Franco-German fund is continuing to see the periphery supported, and that positivity will continue unless there is a major step-down by either France or Germany,” said Henry Occleston, a rates strategist at Mizuho.

He noted that slow progress towards setting up the recovery fund meant hefty bond issuance from the likes of Spain and Italy in the meantime.

Nick Kounis, head of financial markets research at ABN AMRO, said Villeroy’s comments suggested the ECB was willing to deviate more from the capital key under its emergency bond buying programme.

Speaking late on Monday, Villeroy said some euro zone central banks must be prepared to buy more bonds and others fewer to ensure the smooth transmission of monetary policy.

Although the ECB buys government bonds according to each country’s shareholding in the bank, the so-called capital key, the ECB has said it would be flexible and may deviate from this rule with its emergency bond purchases.

Italy has been a key beneficiary of a front-loading of ECB asset purchases in recent weeks.

“The Banque de France Governor is an influential member of the Governing Council, so the change in language needs to be taken seriously. We doubt that he is flying solo on this one,” Kounis said.

At the same time, sources told Reuters that the ECB is drafting contingency plans to carry out its multi-trillion bond-buying programme without the Bundesbank in case Germany’s top court forces the main participant in the scheme to quit.

Rallying stock markets and a fresh wave of euro zone bond supply pushed long-dated German bond yields to one-month highs, with the 10-year Bund yield rising almost 6 bps to -0.43% .

Germany sold just over 4 billion euros of new two-year bonds. Italy also held a bond auction.

Reporting by Dhara Ranasinghe; editing by Kirsten Donovan and
Mark Heinrich

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