UPDATE 2-Italian bond rally fueled by Rome deficit cut, ECB expectation

Abhinav Ramnarayan

* Rome cuts 2019 budget deficit target to placate EU

* Italian 10-yr yield at over one-year low

* ECB speakers double down on stimulus pledge

* Spain, Portugal yields at new record lows

* Money markets price in 50% chance of July rate cut

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Adds graphic, updates prices)

LONDON, July 2 (Reuters) - Italian government bond yields dropped to their lowest levels in at least a year on Tuesday, driven by hopes for a truce in a Brussels budget row and more European Central Bank stimulus.

Many euro zone government bond yields have hit new record lows this week as ECB policymakers unite behind a pledge for more stimulus, benefiting Italy in particular.

Another market concern also eased as Italy cut its 2019 budget deficit target on Monday in an effort to avoid European Union disciplinary action over its public finances.

Italian 10-year government bond yields dropped seven basis points to a new one-year low of 1.857%, a level last before the government of League and 5-Star Movement was formed.

Overall, Italian yields were 3-5 bp lower across the curve, with the 30-year yield at one stage dropping to its lowest level since September 2016.

The closely-watched spread between Italian and German 10-year government bond yields was at its tightest level since September 2018 at 232 bps, when budget clashes between Italy and the EU were in full swing.

"The move is at least partly driven by the general massive drop in (euro zone) yields," DZ Bank rates strategist Christian Lenk said.

"There is also growing optimism of a budget agreement, and a feeling that the European Commission has been less aggressive than expected in punishing Italy," he said, referring to the EU's decision not to immediately impose sanctions on Rome for breaching a budget promise.

He added however, that he does not share the market's optimism, and expects budget clashes to resume in the autumn when Italy is formulating its 2020 budget, potentially hurting Italian debt in the process.

Other euro zone government bond yields edged lower, having dipped to record lows on Monday on the back of dovish comments from ECB policymakers.

Germany's 10-year government bond yield, the benchmark for the region, briefly hit a new record low of -0.365%, but was broadly unchanged on the day.

Spanish and Portuguese 10-year yields dropped by about a basis point each, hitting new record lows of 0.31% and 0.39% respectively.

Euro zone money markets are now pricing in a 50% chance of a 10 basis point rate cut by the ECB in July, up from the 40% chance priced in last week.

(Reporting by Abhinav Ramnarayan; Editing by Kevin Liffey and Alexander Smith)