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LONDON: Short-dated euro zone government bonds outperformed on Monday, with Italy leading the way as political uncertainty eased and speculation grew that the European Central Bank would deliver a bigger interest rate cut next week than previously anticipated.

Italy's prime minister said on Sunday he expected to settle talks over a new government by Wednesday, as the 5-Star Movement and Democratic Party (PD) are working out cabinet posts and a common agenda.

Italian bond yields fell 4 to 8 basis points, having risen on Friday after 5-Star leader Luigi di Maio said his party would only enter a coalition if the PD agreed to a string of policy demands.

But on Monday, the short end of the curve outperformed, with two-year yields tumbling 7 bps to -0.223%, close to its lowest levels since April 2018. Italy's 10-year bond yield fell 6.8 bps to 0.9650%.

The gap between short-dated Italian and German bond yields may tighten further once governmental uncertainty is out of the picture, said Peter Schaffrik, global macro strategist at RBC Capital Markets. Italian two-year bonds now trade at a 65.50-bps yield premium to two-year German debt.

"It's a pretty attractive spread for a relatively moderate risk that you would take," Schaffrik said.

The next hurdle is for 5 Star's members to approve the coalition deal, agreed last week, in a vote on Tuesday.

But across the euro area, ECB rate cut speculation helped short-dated bonds outperform longer dated-peers.

The ECB meets on Sept. 12 and is widely expected to cut rates to boost economic growth and inflation. While a 10 bps cut had already been expected, money markets are ramping up bets on a larger cut, moving to price a more than 60% chance of a 20-basis-point cut.

Germany's two-year bond yield was flat at -0.919% and within sight of record lows from early-2017.

In contrast, 10-year bond yields rose one bps to -0.695% and the 30-year yield was up 3.3 bps at -0.186% as the outcome of Germany's regional elections brought investors some relief.

The election on Sunday saw Chancellor Angela Merkel's conservatives and their Social Democrat (SPD) coalition partners cling on as the largest parties in Saxony and Brandenburg

The short-end outperformance follows hawkish statements last week by some ECB officials that had fuelled speculation the central bank, instead of embarking on fresh asset purchases, could deliver large rate cuts instead, said Norbert Wuthe, rates strategist at Bayerische Landesbank Wuthe.

"The decreasing likelihood of quantitative easing came with an increasing likelihood of rate cuts or even stronger rate cuts," he said.

Also, the news flow from Britain is also likely to keep a bid for bonds. British Prime Minister Boris Johnson summoned his ministers for an emergency meeting, fuelling expectations he was preparing for a snap election should lawmakers this week vote to delay Brexit

British 10-year government bonds saw yields fall 6 bps to 0.42%, the lowest since August 20.

Copyright Reuters, 2019