UPDATE 1-Italian bonds rally as bad loans tumble

Italian government bonds out-performed the rest of the market on Monday after the Bank of Italy published data showing the country's banks shed more than 17 billion euros in gross bad loans in December. Support for riskier assets was reflected in a sell-off in core euro zone paper, with Germany's 10-year government bond yield rising by almost three basis points to 0.11 percent, pulling away from Friday's low of 0.077 percent. Progress in China-U.S. trade talks had lifted sentiment, analysts said.

Italian two- and five-year government bond yields dropped by up to 10 basis points after the Bank of Italy reported a 34 percent year-on-year fall in impaired loans. Bad loans held by Italian banks swelled to 360 billion euros in 2015-2016 following a deep recession and lenders have been working to reduce them in the past two years.

The boost to Italian bonds from the falling stock of non-performing loans came despite reports of a revamp at the Bank of Italy and the expectation of early elections, Commerzbank rates strategist Christoph Rieger said. "(Deputy Prime Minister Matteo) Salvini is seeing the chance of becoming Prime Minister looking at some of the recent surveys," he said. "This won't abolish uncertainty but the markets will probably take it well."

Italy's populist leaders on Saturday promised to replace top officials at the country's central bank, who they said must pay for failing to prevent a spate of banking scandals in which thousands lost their savings. The bond rally also comes despite expected pressure on the Italian government for further fiscal adjustment following the European Commission's downwards revision of its growth forecast.

But analysts at ING said the EU will want to avoid reopening the discussion ahead of EU parliamentary elections in May and as such do not expect any action on the Italian budget yet. Fitch is due to review Italy's credit rating on February 22.

The spread of Italy's 10-year debt over top rated Germany fell to 278.9 basis points having edged closer to 300 basis points on Friday. Demand for core euro zone bonds waned as progress in trade talks between China and the U.S. boosted risk appetite.

China struck an upbeat note on Monday as trade talks resumed with the United States, but also expressed anger at a U.S. Navy mission through the disputed South China Sea. The prospect of early elections in Spain had little impact on the Spanish curve though its 30-year government bond yields rose one basis point.

Elsewhere core 10-year government bond yields in the bloc were about two basis points higher,. Around 14 billion euros of new supply is expected this week with the Dutch treasury due to kick of issuance with a new 2029 bond on Tuesday. (Reporting by Virginia Furness; Editing by Kirsten Donovan)

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