UPDATE 1-German bond yields, Italy bank shares down on European Commission forecasts

German government bond yields hit five-week lows on Tuesday and Italian shares fell, led by the country's banking index, after the European Commission revised down euro area growth forecasts and cut its already gloomy outlook on Italy. The euro zone economy will rebound next year from a slow-down in 2019 and unemployment will fall further, but inflation is likely to stay at this year's levels and below the European Central Bank's target, the European Commission said on Tuesday.

It forecast domestic euro zone growth of 1.2 percent this year, slower than the 1.3 percent it predicted in February. The report prompted further buying of German government bonds -- after an apparent deterioration in Sino-U.S. trade relations led investors to buy safe haven assets on Monday -- and pushed yields down to a five-week low of -0.04 percent . Other core bond yields in the bloc were also around three basis points lower.

The Commission also cut Italy's growth forecast to 0.1 percent, down from 0.2 percent and said the country's deficit could widen further beyond the 3 percent ceiling set by the European Union. Italian government bond yields initially rose to 2.6 percent before pulling back to 2.58 percent, up just one basis point on the day.

While the reaction in Italian bond was muted, the Germany/Italy bond yield spread widened to its most since April 26 at 263 basis points. "The Italy spread did widen on the release of the forecast but there's been a mini recovery," said Peter Chatwell, a strategist at Mizuho in london. "The EU don't seem to be telling us anything we don't know, but the market is using that as a catalyst to re-price."

Italian shares fell into negative territory, with the banking index 1.7 percent lower at 1208 GMT as investors focussed on the deficit forecast. With no changes in the government's spending policies, the country's deficit is set to grow to 2.5 percent of output this year and climb to 3.5 percent in 2020, beyond the 3.0 percent ceiling set by EU fiscal rules, the EC said.

"Clearly that is way beyond what will be deemed acceptable and that has seen the underperformance of Italy," said Richard McGuire, head of rates strategy at Rabobank. (Reporting by Virginia Furness and Josephine Mason; editing by Sujata Rao and Kirsten Donovan)

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