UPDATE 1-Budget optimism lifts Italy's bonds, Cyprus promoted to investment grade

Italian bond yields tumbled on Monday, as a report that Italy's economy minister is set on preventing the 2019 budget deficit rising above 1.6 percent of domestic output boosted investor hopes for a market-friendly budget.

Bond yields in Cyprus also fell sharply after S&P Global late on Friday promoted Cyprus's sovereign debt to investment grade, more than six years after it was downgraded into "junk" territory.

Italy's bond yields slid as much as 12 basis points after the report on Economy Minister Giovanni Tria's plans to keep the budget deficit in check.

Corriere Della Sera daily reported Tria would meet Prime Minister Giuseppe Conte and Deputy Prime Ministers Luigi Di Maio and Matteo Salvini to discuss the budget on Monday, aiming to "pin down some numbers" and decide what funds to allot to the different measures being considered.

Markets have been on edge over Italy's next budget because of the anti-establishment coalition's plans to ramp up public spending and unwind past deficit-curbing measures.

Recent weeks have seen a recovery in sentiment towards Italy after top officials said the government would respect European Union rules on fiscal discipline.

"Some reassuring comments from the finance ministry that they will aim for a budget deficit of 1.6 percent are helping Italian bonds," said DZ Bank rates strategist Sebastian Fellechner.

Analysts said Italian bonds also benefited from reports of a proposal by the League - one of the two parties that make up the government - to give tax breaks to savers who buy Italian debt.

Italy's 10-year bond yield was down almost 10 bps on the day at 2.89 percent, while yields on safe-haven German Bunds touched their highest in more than six weeks at 0.468 percent.

That left the closely-watched gap between Italian and German bonds at around 240 bps.

"I happily stick with my view that the spread will move down through 200 bps during the next couple of months, as clarity emerges on the budget," UniCredit chief economist Erik Nielsen said in a note.

While yields in higher-rated euro zone bond markets crept up, peripheral markets outperformed in the wake of positive rating news.

Portuguese bond yields dipped after S&P on Friday lifted the outlook on Portugal's credit rating to positive.

S&P also lifted Cyprus's rating to BBB- from BB+, citing brighter growth prospects and consolidation in the banking sector.

The investment-grade rating makes Cyprus eligible for ECB bond purchases. To qualify for quantitative easing, a country needs at least one investment grade rating from S&P, Moody's, Fitch or DBRS. All the latter three still rate Cyprus below investment grade.

Cyprus on Monday mandated banks to sell a 10-year bond in a move analysts said was aimed at taking advantage of the positive sentiment following the upgrade.

"The Cyprus upgrade adds to the positive picture in the periphery," said Commerzbank rates strategist Rainer Guntermann.