By Dhara Ranasinghe
LONDON (Reuters) - Germany's 10-year government bond yield hit a five-week low on Friday, as an Italian election and a milestone in German coalition politics this Sunday together with news of stiff U.S steel and aluminum tariffs boosted demand for safe-haven debt.
But Italian bond yields also fell, pushing the gap over German peers to its tightest in two weeks and suggesting some confidence among investors heading into an election weekend.
U.S. President Donald Trump on Thursday unveiled plans for hefty tariffs on imported steel and aluminum to protect U.S. producers. That stoked concerns about a global trade war, rattling stock markets and pushing U.S. and European bond yields down.
In the euro zone, the focus turned to two potentially major risk events this weekend.
On Sunday, Italians vote in a national election that is expected to result in a hung parliament, where no one party or coalition has a majority to form a government. Polls suggest the only group with any chance of getting a parliamentary majority is a center-right coalition built around the 81-year-old, four-time prime minister Silvio Berlusconi.
The election is on the same day as Germany finds out the results of a ballot of Social Democrat party members on a coalition deal with Chancellor Angela Merkel's conservatives -- the outcome of which could seal or end Merkel's hopes for a fourth term in office.
"The base case we have is that we get through Italy with some sort of broad coalition that is market friendly, that Germany resolves its government situation and then there's two years where some of the larger European questions can be solved," said Mark Haefle, global chief investment officer at UBS Wealth Management.
Most euro zone bond yields were down 1-3 basis points.
Germany's benchmark 10-year Bund yield fell 3 bps to 0.61 percent (DE10YT=RR), its lowest level in five weeks.
It has fallen almost 20 bps from more than two-year highs hit last month and is set for a fourth straight week of falls. Weak inflation data this week has helped reassure bond investors that an interest rate rise in the bloc remains some way off.
ELECTION, NO SWEAT
Italy's 10-year bond yield fell two bps to 2.008 percent (IT10YT=RR), its lowest level in almost two weeks. That pushed the gap over German peers to around 138 bps, also its tightest in almost two weeks.
The spread - a key gauge of how investors view relative country risks in bond markets - has narrowed around 10 bps this week - a sign that investors are relatively comfortable holding Italian bonds ahead of a potentially big risk event.
"The benign spread view will be put to the test over the weekend not only by the Italy election, but also by the SPD membership vote in Germany," said Benjamin Schroeder, senior rates strategist at ING. "We still have the feeling that markets are too complacent about the outcomes of this weekend's two votes."
(GRAPHIC: Italian election no sweat for bond market - http://reut.rs/2FehFAS)