UPDATE 3-Italy's 2-year bond yield hits seven-month low ahead of ECB meet

Short-dated Italian bond yields hit their lowest level in seven months early on Thursday ahead of a European Central Bank meeting at which policymakers are expected to provide detail on a new round of cheap loans that should benefit Italian lenders. The ECB will also slash growth forecasts and is likely to provide its strongest signal yet that fresh stimulus is coming, hoping to stop an unexpected slowdown from becoming a downturn.

"There are a number of supportive factors for Italy these days, probably the most important one is the TLTROs," said Commerzbank rates strategist Christoph Rieger, referring to the official name for the ECB loans: targeted long-term refinancing operations. "Also earlier this week, we saw positive data (from Italy) for a change, plus we keep getting stories about new elections and (far-right League leader Matteo) Salvini taking over - something the market seems to like," he added.

Anticipation for these cheap loans have supercharged a rally in Italian debt, though it began in earnest when data this week showed that the Italian economy may be recovering better than expected after slipping into recession last year. Italy's two-year bond yields hit 0.198 pct in early trade on Thursday, before settling at 0.26 percent, still slightly down on the day.

This meant it briefly dipped to its lowest since late May, just before Prime Minister Giuseppe Conte was sworn in to head a coalition of anti-establishment parties, the 5-Star Movement and the League, fuelling worries about the country's spending plans and its future within the single currency bloc. This yield is based on Italy's October 2020 bonds, used by Reuters as the benchmark two-year bond.

Other investors consider Italy's April 2021 bond as the benchmark for Italy's two-year borrowing costs, and that bond was trading at a yield of 0.516 percent on Thursday. Italy's 10-year bond yield dropped to a new five-week low of 2.58 pct, down 3 basis points on the day, while the closely-watched spread over Germany was at 248 bps.

Other euro zone bond yields were flat or a touch lower ahead of the ECB meeting, having already fallen on Wednesday. Germany's 10-year bond yield, the benchmark for the region, was a basis point lower at 0.115 percent. Also on Thursday, France sold around 9.5 billion euros of bonds in a heavily subscribed auction and Spain raised 4 billion euros in a debt auction. (Reporting by Abhinav Ramnarayan Editing by Tommy Wilkes and Jon Boyle)