UPDATE 2-German bonds set for best week this year

* Euro area bonds rally after ECB, yields at April lows

* German yield curve flattest in nearly two months

* Range-bound trading seen, Italian bonds to benefit (Adds Fitch to rate Spain, updates prices)

June 11 (Reuters) – Benchmark German 10-year bonds were set for their best week of the year on Friday and southern European bonds rallied sharply as a dovish outcome to the ECB meeting a day earlier supported government bond prices in the euro area.

On Thursday, the European Central Bank said it would maintain an elevated pace of pandemic emergency bond purchases (PEPP) for the third quarter.

Though it upgraded its economic projections for this year and next, underlying inflation is still expected to stay below the ECB target at least through 2023, suggesting support will be maintained after the PEPP programme, which expires in 2022.

Euro area borrowing costs dropped to their lowest since late April on Friday in a broader fixed-income rally, which also saw Britain’s gilt, U.S. Treasury and Japanese government bond yields fall.

After a brief rise, Treasury yields ignored higher-than-expected May inflation data on Thursday and were set for their biggest weekly decline in a year as investors covered short positions.

“Since (May), the rates market is zeroing in on crowded consensus shorts, forcing position capitulation across the board,” BofA analysts Ralf Preusser and Myria Kyriacou told clients. “This is very visible in price action over the last two days in particular.”

Falling another 2 basis points (bp) to -0.27% on Friday, Germany’s 10-year yield, the euro area benchmark, is down nearly 6 bps this week in its biggest weekly fall in 2021. Bond yields move inversely with prices.

The German yield curve, measured by the gap between two- and 10-year yields, was at its flattest in nearly two months at 41 bps.

Southern European bonds, which outperformed following the ECB session on Thursday, also continued rallying on Friday.

The Fitch rating agency was set to review Spain’s credit rating later on Friday while the country’s 10-year yield was down almost 2 bps at about 0.36%.

Italy’s 10-year yield fell nearly 2 bps to 0.75%, pushing the closely watched risk premium, or spread, over German bonds to a new five-week low of 102 bps.

“The balance of risks argues for range-bound yields over the summer. We expect a selective compression of spreads, with BTPs being the clear winner,” Spyros Andreopoulos, senior economist at BNP Paribas, told clients, referring to Italian bonds.

BNP Paribas analysts expect the risk premium to fall to about 90 bps by late July.

But the focus is also on three of 25 ECB Governing Council members who wanted to reduce the pace of the bond purchases at the meeting, citing the better outlook for growth and inflation, according to Reuters sources.

Klaas Knot, one of the most hawkish members of the council, called on Friday for new European budget rules to maintain an oversized role for government spending for years to come while monetary policy remains constrained.

Another hawk, Austria’s Robert Holzmann, said a rise in the inflation rate above 3% would prompt the ECB to take another look at its policy approach.

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