UPDATE 2-Italian govt bond yields fall after service sector returns to growth

Italian government bond yields fell up to five basis points across the curve on Tuesday on the back of firming services activity in Italy and across the euro zone. In a sign that the economic downturn in Italy could be easing, data showed that its services sector expanded slightly in February after contracting the month before, although new business orders fell into negative territory for the first time in four years.

"The Italian services PMI was better than expected, psychologically it was above the 50 mark that suggests expansion rather than contraction," said Mizuho rates strategist Antoine Bouvet. "Though it should be remembered it is only a minor margin above 50." A Reuters headline that the 5-Star Movement could quit the government may also be contributing to the rally, he added.

"The assumption in the market is that because the 5-Star movement popularity has been declining, it would be replaced by a more market friendly, less fiscally profligate government," he said. Ten-year Italian government bond yields fell to a one-month low of 2.693 percent. Two-year yields fell as much as five basis points to 0.30 percent.

Italian fourth quarter gross domestic product data showed the country's economy shrank by 0.1 percent, raising a preliminary estimate of a 0.2 percent contraction. However, on a year-on-year basis, fourth quarter growth was revised down to a flat reading, compared with a previously reported 0.1 percent rise.

Italy's services data added to a set of more positive readings across Europe. Activity in Spain's services sector beat expectations as new orders rebounded, despite being slightly down overall. This contributed to an acceleration in overall business activity in the bloc though again, this remained lacklustre.

IHS Markit's Euro Zone Composite Final Purchasing Managers' Index (PMI), considered a good measure of overall economic health, rose to 51.9 in February from January's 51.0. That was higher than a flash reading of 51.4 and above the 50 mark separating growth from contraction.

ECB FOCUS The mixed picture in Europe still points to below-trend growth however, ahead of the European Central Bank meeting on Thursday at which analysts are expecting guidance on its plans for targeted loans to banks.

"In the euro zone you have two very different stories, a manufacturing/industrial story where things are not really picking up and it's (services PMI) still below 50 in most countries," said Charles St Arnaud, senior investment strategist at Lombard Odier Investment Management. "But the service sector remains resilient and given that's the most important part of the economy it gives me some comfort. What I am worried about is whether we see the manufacturing weakness gradually feeding into services, for instance if it leads to layoffs."

The services activity data helped peripheral euro zone bond yields fall, while pushing up yields on the bloc's safe haven debt. Spanish and Portuguese 10-year government bond yields were both down around two basis points., German 10-year government bond yields were last up two basis points at 0.181 percent, while its two-year yields rose to a one-year high of minus 0.495 percent,.

Greece set the final yield on its new 10-year government bond at 3.9 percent, with investor orders for the new deal in excess of 11.3 billion euros. Greece aims to raise at least 2 billion euros from the sale, banking sources said. Greek 10-year government bond yields rose two basis points and were last at 3.70 percent. (Reporting by Virginia Furness and Abhinav Ramnarayan, editing by Abhinav Ramnarayan and Emelia Sithole-Matarise)