UPDATE 3-German bond yields hit two-year lows as EU cuts growth forecasts

Germany's 10-year bond yield sank on Thursday to its 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 3-6 basis points (bps), Italy's borrowing costs surged as much as 16 bps on fears that weak growth will exacerbate its fiscal problems.

The Commission said it expected euro zone growth would 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 data recently has reinforced a view that the ECB will struggle to lift interest rates any time soon and may instead have to consider ways 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 fell over 5 bps to 0.105 percent, its lowest since November 2016 and set for its biggest one-day fall in five 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 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 since late 2016 at around 0.54 percent and 0.22 percent respectively. British 10-year gilt yields touched eight-month lows after the Bank of England said it saw the weakest outlook for the UK economy since 2009, while U.S. Treasury yields tumbled 4 bps as global growth fears took hold.

BTP YIELDS SOAR The euro slipped as well, hitting a two-week low of $1.1320 , while a key market gauge of long-term euro zone inflation expectations hit its lowest in over two years at around 1.48 percent.

Italian 10-year yields hit a one-month high of around 2.97 percent as weakening growth raised risks of a wider budget deficit. Five-year yields soared 16 bps, the cost of insuring exposure to Italian sovereign debt and bonds issued by the country's banks jumped and the Italy/German 10-year yield gap widened 18 bps - on track for the biggest one-day spread widening in five weeks.

The European Commission slashed its economic growth forecasts for Italy, saying uncertainty over government policies and higher borrowing costs pushed the country into recession in the second half of last year. (Reporting by Abhinav Ramnarayan, Sujata Rao and Dhara Ranasinghe; Editing by Andrew Cawthorne and Mark Potter)