UPDATE 2-German bond yields sink to two-year lows as EU cuts growth forecasts

Germany's 10-year bond yields sank on Thursday to their lowest level in over two years, taking a step closer to zero percent, after sharp cuts to the European Commission's growth and inflation forecasts fuelled concern about the economic outlook. As yields on top-rated bonds across the bloc tumbled 3-4 basis points, Italy's borrowing costs surged 10 bps on concerns that weak growth will exacerbate its fiscal position.

The Commission said it expects euro zone growth will slow to 1.3 percent this year versus an earlier estimate of 1.9 percent, while inflation is expected to be 1.4 percent, well short of the European Central Bank's target of just below 2 percent. A string of weak economic data in recent weeks has reinforced a view that the ECB will struggle to lift interest rates any time soon and may instead have to consider measures to stimulate the economy, perhaps in the form of a new set of cheap loans to banks.

"Updated ECB projections should also show slower inflation and that could be sufficient for the ECB to decide on new measures," said Commerzbank rates strategist Rainer Guntermann. "These could be more stimulus measures - probably liquidity measures or a change to the interest rate forward guidance."

Germany's 10-year bond yield, the benchmark for the bloc, dropped more than four basis points to 0.118 percent, its lowest level since November 2016 and set for its biggest one-day fall in two weeks. It moved a step closer to zero percent and negative territory -- where it moved to in 2016 when concerns about deflation were at a peak.

Data released earlier this week from bond-trading platform Tradeweb showed that the pool of euro zone government bonds with negative yields rose in January to a nine-month high at almost 40 percent. "I can see why bond markets are reacting the way they are because the data is telling us that recessionary tendencies are increasing," said David Vickers, portfolio manager at Russell Investments in London.

French and Dutch 10-year bond yields fell to their lowest levels since late 2016 at around 0.55 percent and 0.23 percent respectively. British 10-year gilt yields fell to their lowest level this year after the Bank of England said it sees the weakest outlook for the UK economy since 2009.

EURO WEAKENS, BTP YIELDS SOAR The euro slipped as well, hitting a two-week low of $1.1320, down a quarter percent on the day, while a key market gauge of long-term euro zone inflation expectations, dropped to its lowest since Nov 2016 at 1.4807 pct.

In contrast, Italian 10-year yields hit a one-month high of around 2.96 percent as weakening growth raises risks of a wider budget deficit. The European Commission slashed its economic growth forecasts for Italy, saying uncertainty over government policies and higher borrowing costs pushed the country into a recession into in the second half of last year.

The Italy-Germany 10-year bond yield gap was at its widest in two months at 283 basis points and about 14 bps wider on the day -- its biggest one-day spread widening in two months. Italy went into recession in the second half of 2018, and indicators show this downward momentum is continuing, raising concern that Italy's planned spending measures will push the deficit even higher than originally planned.

"The move in Italian bonds also makes sense, because the same amount of fiscal stimulus would cause the deficit to widen much more since GDP growth is falling low," said Rishi Mishra, interest rates strategist at Futures First Info Services. (Reporting by Abhinav Ramnarayan, Sujata Rao and Dhara Ranasinghe; Editing by Andrew Cawthorne)

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