Italian borrowing costs fell on Tuesday, narrowing the gap with its German peers, on signs that Italy's anti-establishment coalition is likely to reach a compromise over the 2019 budget.
In contrast, Germany's benchmark 10-year bond yield rose to four-month highs, as a bearish tone in broader bond markets lingered a day after European Central Bank chief Mario Draghi pointed to a "vigorous" pick-up in underlying inflation.
Italy's ruling coalition, made up of the anti-establishment 5-Star Movement and the League party, is willing to keep the budget deficit below 2 percent of the gross domestic product, a government source told Reuters after a meeting at the prime minister's office over the budget late on Monday.
Italy's La Stampa reported that the government will offer a 2019 deficit plan of 1.9 percent of GDP this week, including a 36 billion-euro ($42.36 billion)investment package. The government must present its budget targets this week.
"Hopes of a compromise is what has had BTPs rallying since the start of trade," said KBC rates strategist Mathias van der Jeugt. "The only dissenting voice now appears to be 5-Star."
In Germany, the euro zone's biggest economy and the euro zone's benchmark government bond issuer, 10-year bond yields rose to a four-month high at 0.54 percent, a day after posting their biggest one-day jump since June.
"Draghi's comments were the trigger for the bond sell-off and the market is very sensitive on the back of that," Commerzbank rates strategist Michael Leister said.
He also noted investors were ratcheting up expectations for when the ECB will raise interest rates. Money market pricing suggests investors now expect a rate rise next September instead of next October. ($1 = 0.8498 euros)