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UPDATE 1-Spanish, Portuguese bond yields hit all-time lows as bunds go more negative

Virginia Furness and Abhinav Ramnarayan

negative@ (Recasts with rising peripheral bond yields, adds quotes, chart)

LONDON, May 29 (Reuters) - Peripheral bond yields in the euro zone fell sharply to record lows on Wednesday as deeply negative German bund yields forced investors to look elsewhere for returns, with even Italy enjoying some demand.

Spanish and Portuguese 10-year yields were down as much as five basis points to record lows of 0.736% and 0.879% respectively , while Italian 10-year yields reversed earlier rises and were last down two basis points on the day to 2.67%.

Safe-haven assets rallied strongly in early trade with Germany's 10-year government bond and 10-year U.S. Treasuries falling after reports that China is ready to hit back against the United States with tariffs on rare earths.

Deeply negative bund yields have encouraged investors to look elsewhere for returns, and in comparison to the rest of the periphery, Spain and Portugal look politically quite stable, especially after the EU parliamentary elections, said DZ Bank rates strategist Daniel Lenz.

"Plus you have the positive ratings action on Portugal last week," Lenz added, referring to Fitch's decision on Friday to change the outlook on Portugal's BBB sovereign credit rating to "positive".

Justin Onuekwusi, portfolio manager at Legal & General Investment Management, said he favoured peripheral debt and French debt over German bonds. "We have increased allocation to Italy and the periphery by selling bunds."

Germany's 10-year government bond yield fell to its most negative in nearly three years, hitting -0.172%, pushing the German curve to its flattest in the same period of time.

In addition, a gloomy outlook for inflation across the bloc has increased investor expectations for more stimulus from the European Central Bank, Rainer Guntermann, rates strategist at Commerzbank, said.

SUBDUED INFLATION

French inflation slowed to its lowest level in nearly two years in May, according to preliminary EU-harmonised data from the INSEE statistics agency on Wednesday.

"It is a harbinger for more subdued inflation from Germany later, and there's pressure on the ECB to provide more colour on its assessment and whether they trust in the economic improvement for the second half, or if more stimulus is needed," said Guntermann.

A gauge of market expectations of long-term euro zone inflation fell to its lowest since 2016 on Tuesday and was last at 1.301%.

Italian bonds were boosted by some positive economic data, while the hunt for yield following the European elections prompted buying of Portuguese and Spanish bonds, analysts said.

Data showed morale among Italian businesses and consumers rose unexpectedly in May, which offered investors hope that the euro zone's third-largest economy continued to grow in the second quarter.

"We have rather positive economic data, beating expectations by a big margin, and that is the trigger for the upturn," said DZ Bank's Lenz.

"We had a very weak second half last year, but a better than expected Q1 this year. Today's business and consumer data is pushing up hopes that things are getting better."

The move lower in Italian yields reverses two days of selling after comments from Deputy Prime Minister Matteo Salvini unnerved investors.

Since his party won 34% support in Sunday's European Parliamentary vote, Salvini has stepped up promises to slash taxes and calls for new EU budget rules, putting Italy again on a collision course with the European Union.

The European Commission is likely to start disciplinary steps against Italy on June 5 over the country's rising debt and structural deficit levels, which break European Union rules, two euro zone officials said earlier this week.

(Reporting by Virginia Furness and Abhinav Ramnarayan Additional reporting by Sujata Rao Editing by Abhinav Ramnarayan and David Holmes)