UPDATE 2-German 10-year bonds set for best day in over a month on U.S-China tensions

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds ECB purchases)

By Dhara Ranasinghe

LONDON, July 27 (Reuters) – Germany’s 10-year bond yields were set for their biggest fall in over a month, pushing back towards two-month lows on Monday as unease in world markets over rising U.S.-China tensions drove investors back into safe-haven assets.

China took over the premises of the U.S. consulate in the southwestern city of Chengdu on Monday after ordering the facility to be vacated in retaliation for China’s ouster last week from its consulate in Houston, Texas.

The worsening relations between the world’s two biggest economies boosted safe havens such as gold and government bonds, allowing German debt to recover from price losses on Friday that followed the stronger-than-expected purchasing managers’ index (PMI).

News on Monday that Germany’s Ifo business sentiment index rose further in July failed to dent a rally in top-rated bond markets, although analysts said German Bund yields would struggle to push past -0.50%.

Germany’s 10-year bond yield was down 5 basis points to -0.49%, their biggest daily fall since June 11, nearing two-month lows hit last week at almost -0.50%. French and Dutch 10-year bond yields were down similarly.

“Risk assets are struggling … while for Bunds the textbook reaction to the PMIs combined with another failed test of the -0.50% level leaves 10-year yields in the middle of the range,” said Commerzbank rates strategist Michael Leister.

Italian bond yields held near recent 4-1/2 month lows, a sign of support for peripheral debt even in the face of world stock market weakness that tends to ripple across risk assets.

10-year yields were down 2 bps to 1.05% in late trade . The gap over benchmark 10-year German Bund yields rose from five-month lows hit earlier in the session, to 153 bps .

European Union leaders last week reached a deal on a 750 billion euro ($878 billion) COVID-19 recovery fund, agreeing to raise billions of euros on capital markets on behalf of the 27 member states, in an act of unprecedented solidarity. That has boosted sentiment towards the euro and peripheral bonds.

“We think (the Italian/German bond yield spread) could tighten another 15-20 bps from here. The number matters less than the direction,” said Jorge Garayo, senior rates strategist at Societe Generale. “The recovery fund is significant because it marks a very important step towards something that was previously taboo – fiscal transfers.”

The European Central Bank upped its bond purchases last week, after it bought the lowest amount since purchases were ramped up in March the week before, data showed.

($1 = 0.8542 euros)

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