UPDATE 1-Investors stick with European safe-haven bonds despite trade talk hopes

European safe-haven government bond yields fell back towards six-week lows on Tuesday, as a surprise drop in German investor morale offset a more conciliatory tone in China-U.S. trade talks.

Investors had rushed for safety on Monday after China announced it would slap tariffs on U.S. goods in retaliation for a U.S. move last week to target more imports from China. Italy, where government bond yields hit a new 2-1/2 month high this week on U.S.-China trade tension-induced risk aversion and worries about political infighting in Rome, raised 6.75 billion euros in new bonds on Tuesday. Nordea analyst Jan von Gerich, said the auction went "quite well but not great".

The prospect of a deepening trade conflict between the world's two biggest economies has rattled investors, but on Tuesday China's top diplomat said China and the United States had the "ability and wisdom" to reach a deal that was good for both. U.S. President Donald Trump said he thought talks in Beijing would be successful.

The 10-year German government bond yield initially rose 2 basis points to -0.057%, away from a six-week low of -0.07% on Monday. But signs of investor nervousness were clear as the yield later reversed to -0.07%. The ZEW economic sentiment survey showed the mood among German investors deteriorated unexpectedly in May.

"The market is overly sensitive (to headlines). The underlying situation is quite bad. The words we are hearing from China are not something we are used to," said Nordea's von Gerich. Together with signs of a weakening eurozone economy, "the case is becoming clearer that yields are not heading higher any time soon," he said.

Many analysts believe it is very difficult for core euro zone debt yields to rise sustainably given concerns about the health of the economy and trade war fears. Christian Lenk, an analyst at DZ Bank, described the market's approach to the trade talks as "bipolar", with investors piling into German bunds on negative days - only to reverse those positions when the mood turned positive.

"That ping-pong feeling that markets are feeling with trade talks is something that's likely to continue until we find some concrete results," he said. French government bonds have enjoyed strong demand this year and data on Tuesday showed that Japanese investors bought a record amount of French bonds in March.

The 10-year French government bond yield rose slightly on Tuesday to 0.342%, further away from 2-1/2 year lows touched in March. Italian government bond yields were little changed on the day, just below 2-1/2 month lows touched this week. The 10-year yield hovered around 2.669%.

Italy sold the top planned amount at a bond auction on Tuesday but paid higher yields due to growing concerns over political infighting in the run-up to European elections in late May. The Rome-based Treasury auctioned three-, seven- and 30-year nominal BTP bonds, with orders totalling 1.46 times the 6.75 billion euros ($7.6 billion) sold.

Italian bond yields have risen since a warning last week from the European Commission that public finances would deteriorate further and since politicians in Rome raised the possibility that Italy could breach EU rules on public spending. Analysts said they expected public discord between the two ruling Italian parties to grow in the run-up to European elections.