European yields rise on ECB comments; Italy eyed

* Fiscal slippage concerns dominate investor concerns

* Italian debt offers some of highest yields in low volume market

* Euro zone periphery government bond yields http://tmsnrt.rs/2ii2Bqr (.)

By Saikat Chatterjee

LONDON, May 14 (Reuters) - Benchmark German 10-year bond yields climbed to a 2-1/2-week high after the European Central Bank's Francois Villeroy de Galhau said policymakers could give new guidance on the timing of its first rate hike as the end of its bond stimulus approaches.

The move higher in German debt - 10-year yields posted their biggest daily rise in three weeks - rippled across the core European bond market with French and Belgian bond yields up on the day as the comments caught markets off guard.

The Bank of France governor said that whether the decision to end the European Central Bank's net asset purchases came at its September or December meeting was "not a deep existential question".

With (Other OTC: WWTH - news) the U.S. Federal Reserve well into its policy-tightening cycle, investors are focusing on when will other central banks follow suit in unwinding 2008 financial-crisis era unconventional policies such as quantitative easing which have pushed bond yields to record lows.

"I think the effect of quantitative easing is peaking and we see plenty of upward pressure on government bond yields globally as term premium remains very low," said Paul O'Connor, head of Janus Henderson's head of multi-asset investing, whose funds manage 5 billion pounds.

German 10-year bond yields rose to 0.60 percent, its highest levels since April 26 and were up 4 basis points on the day. Two-year yields were up by a relatively lesser 2 basis points.

Both French and Belgian ten-year bond yields were up 3 basis points respectively.

Central banks have been gradually reducing their presence in the bond markets. JP Morgan data showed 2017 was the peak in quantitative easing with about $2 trillion being pumped into global markets which has had an "anaesthising effect" on financial markets.

That is expected to drop to less than half in 2018 and turn into negative territory next year at a time when the U.S. is expected to inject a large dollop of fiscal stimulus.

ITALIAN CONCERNS

Yields on peripheral debt such as Spain and Portugal remained subdued as broader market risk appetite remained firm with only Italy the sole exception as concerns that a new coalition might push fiscal deficit higher.

Both Italy's anti-establishment 5-Star Movement and the far-right League neared a deal that they hope will fuse their very different election platforms into a workable coalition government, hours before pivotal talks with the country's president.

Though this particular combination was initially greeted as the worst case outcome for Italian markets before a general election, sentiment has since become a bit more optimistic due to an improving economy and the European Central Bank operating with an exceptionally loose monetary policy.

But that optimism turned into caution on Monday with benchmark 10-year Italian bond yields edging 3 basis points higher to 1.91 percent not far away from a six-week high of 1.94 percent hit last week.

Some of the policies being hawked by the Italian coalition taking shape as the next government include slashing taxes for companies and individuals, boosting welfare provision, cancelling a scheduled increase in sales tax and dismantling a 2011 pension reform which sharply raised the retirement age.

That is expected to increase the fiscal deficit from an estimate of 1.6 percent of GDP this year from 2.4 percent in 2017 though investors waited for details.

Italy’s FTSE MIB is one of the best-performing equity indices worldwide year-to-date as the market focuses on a stronger economy and, despite hitting a six-week high last week, 10-year Italian debt remained a third below a eurozone-debt crisis peak of 7.32 percent hit in November 2011.

Some analysts such as Nomura believe that most investors have held on to their Italian bond holdings despite the growing concerns of fiscal loosening from the new government, as Italian debt offers some of the highest yields in the European investment grade space in a low-volatility environment.

Elsewhere, spreads between two-year U.S. and German debt held below a 29-year high of nearly 312 basis points hit on Friday.

In terms of supplies this week, Germany, France and Spain are entering the bond market this week with new issuance though proceeds from redemption of maturing debt is expected to comfortably take care of the supplies, according to Thomson Reuters and Mizuho data.

(Reporting by Saikat Chatterjee; Editing by Angus MacSwan)