UPDATE 2-Euro zone bond yields slide on Brexit and trade fears

German bond yields fell back towards 2-1/2 year lows on Friday as the collapse of Brexit talks in Britain boosted higher-rated debt and worsened a mood among investors already nervous about trade tensions.

Both French and Dutch 10-year government bond yields touched 2-1/2 year lows and there was some respite for Italian bonds, with those yields down as much as six basis points. Analysts said this was more down to position-covering ahead of the weekend than any major easing in concern about Italian risks, however.

Talks between Britain's two biggest parties over a Brexit deal collapsed, reviving doubts whether Britain can avoid leaving the European Union without a deal. The opposition Labour party blamed Prime Minister Theresa May's crumbling government, and investors are now bracing for a contest to succeed her.

"It's the additional uncertainty that's been injected into the market as a result of the likely leadership campaign and the real lack of clarity about what that means for Brexit," said Sarah Hewin, an economist at Standard Chartered, pointing to the renewed prospect of a no-deal Brexit and a possible national election. The 10-year British government bond yield dropped six bases.

Adding to the nervousness, rising trade tensions between the United States and China, the world's two biggest economies, have fuelled concern about global growth. Tough words on trade from China's media on Friday drowned out upbeat news on the U.S. economy and corporate earnings, U.S. Treasury yields, which rose on Thursday after the strong U.S. data, also fell.

French and Spanish 10-year bond yields were set for their biggest weekly drop in around two months, down nine and 13 bps respectively. There have been steep falls in yields across major bond markets this year as weaker global growth and a shift to a more dovish stance from central banks creates a favourable backdrop for fixed income.

"Bond markets in general, especially (German) Bunds, are telling us they don't see many good things going on in the next one (to) two years," said Neil Dwane portfolio manager and global strategist at Allianz Global Investors. Renewed concern about Italy, the euro zone's third-biggest economy, has also fuelled the demand.

Deputy Prime Minister Luigi Di Maio said on Friday he was not worried over possible EU sanctions in case of a violation of fiscal rules, as he was confident European leadership would change after this month's European Parliament elections. Investors have been on edge since Deputy Prime Minister Matteo Salvini said on Tuesday that Rome should be ready to break an EU deficit ceiling of 3% of gross domestic product and push debt to 140% of GDP if needed to fight unemployment.

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