×

South European yields drop as investors expect inflation damp squib

* Euro zone inflation expected at 1.2 pct, well below ECB target

* Unwinding of stimulus likely to be gradual, analysts say

* Italian, Portuguese and Spanish yields drop 3-4 bps

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr

LONDON, July 31 (Reuters) - Southern European government bond yields slipped on Monday as euro zone inflation for July was expected to fall well short of the European Central Bank target, thereby weakening the case for a rapid unwinding of monetary stimulus.

On Friday, euro zone yields had shot up across the board, with Germany's 10-year borrowing costs hitting 19-month highs, after German inflation for July beat expectations, rising 1.5 percent rather than the 1.4 percent forecast by most.

But the move proved to be short-lived, as most analysts realised that this wasn't enough of a surprise to significantly impact the figure for the entire bloc.

On Monday, Italian, Spanish and Portuguese bonds, seen as the biggest beneficiaries of central bank stimulus, outperformed the rest of the market, dropping 2-4 basis points.

Higher-rated government bond yields were flat to a touch higher.

A flash estimate of euro zone inflation is expected to come in at 1.3 percent for the month of July, according to a Reuters poll. The ECB targets inflation of "just below 2 percent".

RBC economists, whose expectation for euro zone inflation is in line with the consensus, also believe that "core inflation" - which excludes energy and processed food prices - could fall back a touch this month.

The Reuters poll showed that general expectations are for this figure to hold steady at 1.1 percent. Both figures are due out at 0900 GMT, as are the equivalent numbers for Italy.

"Either way, we still don't see intrinsic inflationary pressures in the euro area as sufficiently strong to allow the ECB to attempt anything other than a very gradual withdrawal of its stimulus measures," the RBC economists said in a note.

Over the past month, expectations that the ECB will end extraordinary stimulus sooner rather than later have grown.

Germany's 10-year borrowing costs are more than double what they were in late June, when the bloc's top policymaker, Mario Draghi, said he was open to policy tweaks in a speech in Sintra, Portugal.

Most analysts now expect the ECB to announce tapering of its 2 trillion euro bond-buying scheme this autumn, and begin the process in 2018.

"I think the assessment of inflation will be in autumn when central banks come back from vacation," said DZ Bank strategist Sebastian Fellechner. "But given volumes are quite low in the summer, any surprise today could affect yields."

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.bi z / c m s / ? p a g e I d = l i v e m a r k e t s

(Reporting by Abhinav Ramnarayan; Editing by Andrew Heavens)