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UPDATE 1-Italy's bond yields set for biggest monthly drop since 2015

* Italian 10-year bond yields down 33 bps in Oct

* Set for biggest monthly drop since July 2015

* Sentiment boosted by ratings upgrade, ECB policy

* Euro zone inflation, Q3 GDP data due

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

LONDON, Oct 31 (Reuters) - Italy's borrowing costs were set to end October with their biggest monthly decline in more than two years after a surprise ratings upgrade, the extension of the European Central Bank's ultra-easy monetary policy and the approval of a new electoral system.

Trade was generally subdued because of a public holiday in Germany, the euro zone's benchmark bond issuer, and most yields were a touch lower before inflation and economic growth reports.

Peripheral bond markets, which have seen some eye-popping moves in recent days, remained in the spotlight.

Italy's benchmark 10-year bond yield fell to its lowest level in around 10 months at 1.837 percent. It is down around 33 basis points this month, on track for the biggest monthly drop since July 2015, according to Tradeweb data.

Their decline outstrips the rest of the euro zone's. It comes against a backdrop of recent positive news for Italy, the region's third-biggest economy.

Worries about a coming national election have been eased by the Italian parliament's approval of a new electoral system that is expected to handicap the anti-establishment 5-Star Movement and favour mainstream political blocs.

In addition, the ECB said it would extend its asset purchase programme well into next year, albeit at a reduced amount, boosting peripheral bond markets. Spanish bond yields fell to their lowest level in six weeks on Tuesday at 1.48 percent .

Italy, a key beneficiary of the ECB scheme, got another lift when Standard & Poor's unexpectedly raised its sovereign rating for Italy to BBB on Friday, its first such increase for Italy in at least three decades.

S&P said the rise from a previously given BBB- was justified because of Italy's strengthening economic outlook, growing investment, a steady uptick in employment and improvements at its debt-laden banks.

"The ECB provided the necessary backdrop, while the electoral law is important for the long-term outlook because election risk was always looming in the background for many people," said ING senior rates strategist Benjamin Schroeder. "And the ratings upgrade was the cherry on top."

Top-rated German bond yields are down 10 basis points this month. That has left the gap between Italian and German bond yields at 148 bps, close to its lowest levels since December 2016.

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 Dhara Ranasinghe, editing by Larry King)