UPDATE 2-Weak data lifts euro zone bonds, Spanish market brushes off election risk

Euro zone bond yields fell on Wednesday after data showed a larger-than-expected drop in industrial production in the bloc, while the Spanish bond market held firm after parliament voted to reject its 2019 budget. Further evidence of slowing growth in the euro zone pushed long-term market inflation expectations to new lows, while putting downward pressure on bond yields in the bloc.

The European Union's statistics office Eurostat said industrial output in the 19-country currency union fell 0.9 percent month-on-month for a 4.2 percent year-on-year decline. Germany's 10-year government bond yield, the benchmark for the region, fell to as low as 0.119 percent. It drifted higher as U.S. Treasury yields rose after data showed a rise in U.S. consumer prices when food and energy are stripped out.

In late trade, most core 10-year bond yields were down around 1 basis points, while a key measure of the market's long-term euro zone inflation expectations fell below 1.44 percent to its lowest in over two years. The steepest yield falls came in southern Europe on the back of a rally in risk sentiment.

"There has been a lot of appetite for the periphery, there is appetite for risk in general after so many days of the opposite," said BBVA bond strategist Jamie Costero. Italian bond yields fell as much as nine bps across the curve.,,.

Spanish bond yields were largely unmoved after Spain's parliament rejected the socialist government's 2019 budget proposal on Wednesday, Prime Minister Pedro Sanchez's first major legislative defeat. The rejection raised the chances the government will call a snap general election.

"Let's assume we go to elections from here. It's not the worst thing for Spain because, judging by the polls, we will get a working agreement between right-wing parties," said Lyn Graham-Taylor, fixed income strategist at Rabobank. "At the moment Spain has no working government and obviously the market doesn't like uncertainty, but you can see why Spanish yields are largely flat on the day."

The spread of 10-year Spanish debt over top-rated Germany briefly widened to 111.1 basis points. Spanish 10-year bond yields were last down 0.5 bps at 1.24 percent.

Natixis rates strategist Jean-Christophe Machado said the limited price moves suggest investors are more concerned with Brexit developments and news flow out of Italy. "The fact that Italy is in a bad position has given Spain a boost," he said. "If you want to be diversified, you go for Spain. The Spanish bond didn't blink with the BTP (Italian yield) widening."

However, Machado said Spanish bonds were in the longer term vulnerable in the face of further negative developments in both BTPs and Brexit. (Reporting by Virginia Furness; Additional reporting by Dhara Ranasinghe; Editing by Catherine Evans)

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