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UPDATE 1-German bond yields sink as investors shelter from trade war, Italy noise

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* German 10-year bond yield hits new 2-1/2 year low

* Euro zone GDP data fails to calm investor jitters

* Italian yields extend sharp rise on budget concerns

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Recasts with German bund yield drop, adds new quote)

LONDON, May 15 (Reuters) - German bond yields sank further into negative territory on Wednesday as investors sought safety in the face of festering trade tensions between the United States and China and renewed worries about Italy's budgetary plans.

Despite data showing the German and wider euro zone economies grew in line with expectations in the first quarter, investors flocked to safe-haven bonds.

The German economy's return to growth was helped by higher household spending and a booming construction industry, but the increase is probably not the beginning of a sustained recovery, wrote analysts from Capital Economics in a note.

Peter Chatwell, head of rates strategy at Mizuho, put the demand for safe-haven bunds down to investor nerves about weak Chinese data, U.S.-China trade tensions, and more posturing from the Italian governing parties ahead of European parliamentary elections later this month.

"All of this is serving to put markets in a risk-off mode, generating a bid for bunds, and bearishness in BTPs (Italian government bonds), which are vulnerable," he said.

The 10-year German bund yield dropped to its lowest since October 2016. The yield was last down 4 basis points at -0.112% .

U.S. Treasury yields have also been falling as investors look for safer places to park their cash - the 10-year yield dropped 4 basis points to a seven-week low of 2.377% .

ITALIAN DISCORD

Southern European government bond yields, especially those in Italy, have underperformed this week, with analysts citing anti-austerity rhetoric and risk-aversion.

Short-dated Italian government bond yields extended the sharp rise seen on Tuesday after deputy prime minister Matteo Salvini said that Rome was ready to break EU fiscal rules.

Two-year yields jumped eight basis points to 0.819%, the highest since November.

Italy's 10-year government bond yield also rose to new 2-1/2 month highs of 2.78%, up 4 basis points on the day.

This is not the first time an Italian politician has challenged EU budgetary rules; last week Salvini said Rome was ready to push Italy's budget deficit above the EU's 3% ceiling.

But Salvini's comments came at a time of heightened sensitivity to Italian risk due to broader investor nervousness, the proximity of the European Parliament elections and after a lacklustre Italian bond auction on Tuesday.

His remarks also elicited a further show of discord between the ruling parties. Salvini's coalition partner and leader of the 5-Star Movement Luigi di Maio told reporters it was "pretty irresponsible" to create market tensions by speaking about increasing the high debt level.

Investors had hoped that a breakdown in the coalition would result in a more fiscally prudent, right-wing government.

"This is not good news especially after the rumours of a break-up of the ruling coalition after the European election," said Daniel Lenz, rates strategist at DZ Bank.

While jitters have sent investors seeking safety in German debt, not everyone thinks the move is justified.

"Markets seem to have ignored a less dovish stance from the Fed as well as some recovery in the EUR data," analysts at TD Securities told clients.

"This leads us to question (as to whether) the move in core rates has been overdone. We see risks more skewed towards higher Bund yields than edging below the -10bps level."

(Reporting by Virginia Furness and Tommy Wilkes with additional reporting by Sujata Rao Editing by Mark Heinrich)