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UPDATE 1-German bond yields drop after N.Korea missile test, euro surge

* North Korea missile test boosts safe-haven German bonds

* German 2-yr yields at 4-month low before Schatz sale

* Euro hits $1.20, adds downward pressure on yields

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

LONDON, Aug 29 (Reuters) - Germany's borrowing costs hit their lowest level in months on Tuesday as investors rushed to buy up one of the safest securities in the world after North Korea fired a ballistic missile over Japan.

North Korea's ballistic missile test early on Tuesday prompted warnings for residents to take cover while provoking a sharp reaction from Japanese Prime Minister Shinzo Abe and other leaders.

"We are seeing a classic risk-off pattern after Pyongyang fired the ballistic missile," said DZ Bank analyst Rene Albrecht, pointing to U.S. Treasuries, Japanese yen and gold as examples of safe haven assets that are all in demand on Tuesday.

The yield on Germany's 10-year government bond , the benchmark for the euro zone region, fell 3 basis points to 0.34 percent, the lowest since June 28.

The yield on short-dated German "Schatz," sank further into negative yielding territory, hitting its lowest level in over four months at minus 0.76 percent.

The move was particularly eye-catching given that Germany is due to sell 5 billion euros of two-year bonds later on Tuesday.

Under normal circumstances, investors sell outstanding bonds just ahead of a bond sale to make space for the new supply, pushing yields higher.

In keeping with the jittery mood, riskier assets underperformed on Tuesday.

The gap between lower-rated Southern European government bond yields and their better-rated counterparts increased, and Italy's 10-year bond yield spread over Germany widened 3 basis points to 175 bps.

"In times of higher political tensions, there is more demand for Bunds than for peripheral bonds," said Albrecht of DZ Bank.

A stronger euro also put downward pressure on euro zone government bond yields.

The single currency hit $1.20 for the first time since January 2015 on Tuesday, adding to an expectation that reduced import prices may keep inflation low and delay the European Central Bank's withdrawal of stimulus.

"Euro strength is putting resilient inflation expectations to the test and likely signs for slipping HICP core inflation over the coming days should further weigh on break-evens," Commerzbank analysts said in a note.

A gauge of long-term inflation expectations in the euro zone, the five-year forward rate, has been trading at around 1.59 percent, well below the ECB's target for less than 2 percent.

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(Reporting by Abhinav Ramnarayan; Editing by Richard Balmforth)