* German industrial output falls in June, pushing yields lower
Expectations for a 'slow taper' keeps demand strong for bonds
* Italy-Germany spread close to its tightest level of 2017
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Writes through)
By Abhinav Ramnarayan and Dhara Ranasinghe
LONDON, Aug 7 (Reuters) - Euro zone government bond yields dropped on Monday as an unexpected decline in German industrial output added to expectations that the withdrawal of stimulus in the bloc will only be gradual.
Germany's 10-year government bond yield was close to one-month lows after data showed industrial output in the euro zone's biggest economy unexpectedly fell 1.1 percent in June from a month earlier.
"This is a market that wants to rally, the backdrop is very supportive, there's not much supply this week and there's a general sense that it will be a slower taper from the ECB (than previously thought)," said Mizuho strategist Peter Chatwell.
In recent weeks, expectations that the European Central Bank will end its bond-buying scheme sooner rather than later pushed up Germany's borrowing costs. But after ECB chief Mario Draghi struck a cautious note following a recent policy meeting, this move was tempered.
On Monday, the yield on Germany's 10-year government bond dropped a basis point to 0.46 percent, close to the one-month low of 0.45 percent hit on Friday and well below the July high of 0.59 percent.
Italian, Spanish and Portuguese 10-year government bonds were even more in demand, with yields dropping 2 bps each.
At 153 bps, the Italian yield spread over Germany was close to its tightest level of the year.
"We're confident that there is significant further room for the market to rally, and we think it's going to be of more benefit for the higher-yielding bonds," said Chatwell of Mizuho.
He said there was a perception that investors still had money to put to work within European fixed income.
Earlier, there was a brief blip when rising U.S. Treasury yields following Friday's strong payroll figure pushed German bond yields higher. That reversed as the session wore on.
The ECB said on Monday that its money printing accelerated last week: the central bank bought a net 11.998 billion euros of public sector assets, above the 9.686 billion euros it purchased a week earlier.
In June, the ECB bought more than 2 billion euros of Italian and French bonds in excess of what it was supposed to, moving further away from a rule aimed at ensuring its stimulus is evenly spread across the euro zone.
(Reporting by Dhara Ranasinghe; Editing by Larry King)