Italy's bond market cheers budget deal with EU

* Italy strikes budget deal with EU Commission- official

* Italian 5-year bond yield lowest since Sept

* Italy/German bond yield gap tightens

* Broader bond markets await Fed meeting

* Belgian bonds underperform after PM steps down (Updates pricing, adds Conte comments)

By Dhara Ranasinghe

LONDON, Dec (Shanghai: 600875.SS - news) 19 (Reuters) - Italy's two-year bond yield hit its lowest in almost seven months on Wednesday, following news that Italy had reached a deal over its 2019 budget with the European Commission.

The agreement is not ideal but stops EU disciplinary steps against Rome over excessive borrowing, Commission Vice President Valdis Dombrovskis said on Wednesday.

The news, which broke late on Tuesday, signals an end to weeks of wrangling that had shaken bond markets.

After initially refusing to budge on its expansionary budget plans and launching verbal assaults on EU commissioners, Italy's populist government relented last week and submitted a revised plan, including a deficit target of 2.04 percent of GDP.

"It is clear that the European Commission doesn't want a harsh confrontation with the Italian government - next year is an election year and it will be delicate," said Sergio Capaldi, fixed income strategist at Intesa Sanpaolo (Amsterdam: IO6.AS - news) .

The revised deficit figure is down from an original target of 2.4 percent, itself an increase from 1.8 percent this year. The initial proposal was rejected by the European Commision for breaching EU fiscal rules.

Italian Prime Minister Giuseppe Conte on Wednesday outlined measures to help reach the new deficit target including selling real estate and cuts to the highest pensions. At the same time he lowered the 2020 target to 1.8 percent.

Relief that the budget saga may be drawing to a close was evident in the bond market.

Italy's two-year bond yield briefly slid 14 basis points to 0.395 percent, its lowest level since late May -- when Italy was gripped by a political crisis that on May 29 sparked the biggest one-day jump in two-year yields in 26 years.

Five-year Italian yields fell to 1.797 percent, the lowest since September, and 10-year yields were down 18 bps at 2.76 percent.

The Italian/German 10-year yield gap narrowed to around 251 bps, the tightest since late September. That spread stood at 268 bps in late Tuesday trade.

Analysts said that because that spread had come in sharply in the past two weeks on hopes of a budget deal, further tightening was likely to be limited for now.

"This is very short-term relief for Italian bonds. In the medium-term I do not buy the fact that the spread will narrow in a sustainable way," said Capaldi.

Analysts at UniCredit (EUREX: DE000A163206.EX - news) said in a note that caution was still warranted.

"First (Other OTC: FSTC - news) , there are still no details available on the agreement. Second, spreads have come down significantly since mid-November ... which increases the risk of a sell-the-fact reaction. Third, the first months of 2019 will be challenging for Italy from a funding perspective."

January is the busiest month for Italian bond supply and, with the European Central Bank withdrawing its stimulus, the bid for Italian bonds may be depleted.

Yields in broader euro zone bond markets crept up but investors were generally sidelined before a U.S. Federal Reserve rate decision later in the day.

Belgium's bonds underperformed after its Prime Minister Charles Michael resigned after a no-confidence motion, with the 10-year yield rising 3 bps to 0.77 percent.

(Reporting by Dhara Ranasinghe, additional reporting by Virginia Furness, editing by Louise Heavens and John Stonestreet)