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UPDATE 1-Hopes of budget reprieve lift Italian bond market

Dhara Ranasinghe

* EU to pause budget crackdown on Italy - FT

* Italian bond yield drop after article

* Broader EZ bond yields also lower

* German business sentiment lowest since 2014 - Ifo

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Adds chart, context, adds comment)

LONDON, June 24 (Reuters) - Italy's government borrowing costs fell on Monday after a report that the European Commission will this week hold off on disciplinary action over Rome's fiscal targets, lifting hopes that a compromise with Brussels will be found.

Bond yields across the bloc fell as news that German business morale dropped in June to its lowest level since November 2014 reinforced ECB rate-cut expectations.

It was Italy's day in the spotlight after the Financial Times reported that the Commission will hold off from taking action over the country's rising debt levels.

Italy's 10-year bond yield dropped as much as 9 basis points to 2.076% at one stage, nearing more than one-year lows hit last week.

But it was back at around 2.12% by mid-morning, perhaps reflecting the continued political uncertainty that has plagued the euro zone's third largest country over the past year.

Deputy Prime Minister Matteo Salvini last week threatened to resign unless he was able to push through at least 10 billion euros ($11 billion) of tax cuts.

"The fact that Salvini is willing to push ahead with tax cuts and there is turbulence in the coalition is not good news for Italy," said DZ Bank rates strategist Daniel Lenz.

"But the market is reacting more to the FT article today."

The Commission wants Italy to reduce its debt this year and next and has opposed the wide tax cut plans of the ruling coalition if they are not offset by new revenues or spending reductions - options that Rome has dismissed.

Analysts said there were other reasons for the recent solid performance of Italian bonds.

For starters they offer some of the highest yields among major government bond markets. Expectations are high for ECB monetary easing soon following a hint by ECB chief Mario Draghi last week, overshadowing Italy's domestic risks for now.

Hopes for a budget compromise between Rome and Brussels have also been boosted by a perception that an increase in fiscal spending across Europe to support economic growth in the face of a global trade war is likely.

"Draghi's heavy hints at a possible imminent return of QE (quantitative easing) last week are... also creating a very constructive backdrop for Italian debt," Rabobank said in note.

The cost of insuring Italian bonds against the risk of a default has fallen sharply this year, while five-year bond yields are down almost 60 bps.

Waning hopes for progress in China-U.S. trade talks at this week's G20 meeting and fears of a confrontation with Iran also bolstered demand for safe-haven debts.

Germany's Bund yield fell 3 bps to minus 0.31%, nearing last week's record lows at around minus 0.33%.

Most other 10-year euro zone bond yields were down 2-4 bps on the day .

"Any high hopes ahead of the G20 meeting may be disappointed," said Benjamin Schroeder, senior rates strategist at ING.

"In the end, uncertainty will persist and central banks could still be pushed closer to invoking their contingency plans."

(Reporting by Dhara Ranasinghe; editing by John Stonestreet and Ed Osmond)