LONDON, May 8 ― German government bond yields hit five-week lows yesterday and Italian shares fell, led by the country's banking index, after the European Commission revised down euro area growth forecasts and cut its already gloomy outlook for Italy.

The euro zone economy will rebound next year from a slow-down in 2019 and unemployment will fall further, but inflation is likely to stay at this year's levels and below the European Central Bank's target, the European Commission said on Tuesday.

It forecast domestic euro zone growth of 1.2 per cent this year, slower than the 1.3 per cent it predicted in February.

The report prompted further buying of German government bonds ― after an apparent deterioration in Sino-US trade relations led investors to buy safe haven assets on Monday ― and pushed yields down to a five-week low of -0.04 per cent .

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Other bond yields in the bloc were also around three basis points lower.

The fall in rates sets a good tone for Ireland's 2050 syndication later this week. Irish 10-year government bond yields fell to 0.51 per cent, their lowest since December 2017, while Ireland's 30-year benchmark touched a three week low of 1.33 per cent.

Italy in focus

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The report also renewed investor focus on Italy's economic outlook, particularly its budget deficit. Italy was set on a collision course with the EU over its spending plans last year, prompting investors to sell its government bonds, but Rome made a last-minute concession to abide by EU rules.

The Commission also cut Italy's growth forecast to 0.1 per cent, down from 0.2 per cent, and said the country's deficit could widen further beyond the 3 per cent ceiling set by the European Union.

Italian 10-year government bond yields hit a day's high of 2.6 per cent, before pulling back to 2.59 per cent.

While the reaction in Italian bonds was muted, the Germany/Italy bond yield spread reached its widest since April 26 at 263 basis points.

“The Italy spread did widen on the release of the forecast but there's been a mini-recovery,” said Peter Chatwell, a strategist at Mizuho in London. “The EU don't seem to be telling us anything we don't know, but the market is using that as a catalyst to re-price.”

Italian shares fell into negative territory, with the banking index 1.7 per cent lower at 1208 GMT as investors focussed on the deficit forecast.

With no changes in the government's spending policies, Italy's deficit is set to grow to 2.5 per cent of output this year and climb to 3.5 per cent in 2020, beyond the 3.0 per cent ceiling set by EU fiscal rules, the EC said.

“Clearly that is way beyond what will be deemed acceptable and that has seen the underperformance of Italy,” said Richard McGuire, head of rates strategy at Rabobank.

Economy minister Giovanni Tria shrugged off the EU forecasts, saying they reflected the government's own outlook and were “more political than economic” as they did not consider government commitments in its 2020 budget to cut the deficit. ― Reuters