UPDATE 2-Italian bond rally pauses but yields still near 2016 lows

Virginia Furness

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Reflects latest yields)

LONDON, July 4 (Reuters) - A powerful rally in Italian government bonds paused on Thursday, though yields were still near their lowest levels since 2016 as Italy dodged the threat of EU disciplinary action and on bets the ECB would retain its dovish stance under Christine Lagarde.

Italian BTP government bond yields rose 5-7 basis points across the curve on the day, but the 10-year yield is still down about 44 bps this week in what has been one of the most powerful rallies for years.

News of the European Commission's decision not to pursue an excessive deficit procedure crowned this rally on Thursday.

In a new concession made close to the deadline, Rome offered a structural improvement of 0.45%, data published by the Commission on Wednesday showed. The headline deficit is now forecast at 2.04% this year.

It is the second time in six months that the European Union has stepped back from a debt procedure against Italy, a sign of Rome's willingness to compromise but also of Brussels' lenient interpretation of EU fiscal rules.

Italian 10-year bond yields pulled back after the massive 50 basis point rally seen already this week, but were still at 1.67%, having risen as high as 3.78% last year.

The Italy/Germany bond yield spread briefly narrowed to its tightest since May 2018 at 194 basis points, but later pulled back to trade at around 203 bps.

"Todays move is probably some profit taking, and there is less liquidity in the market so you should be wary about that, said Pooja Kumra, European rates strategist at TD Securities.

She said she does not expect to see a change in the direction of yields overall following yesterday's reaction to Lagarde's appointment to succeed Mario Draghi, softer data and the dovish tone from Bank of England chief Mark Carney on Tuesday.

Government borrowing costs across the single-currency bloc had already tumbled to record lows after EU leaders agreed late on Tuesday to name Lagarde, currently head of the International Monetary Fund, to lead the European Central Bank.

She is expected to continue the dovish stance of current ECB president Draghi and introduce more monetary easing measures.

Most euro zone 10-year bond yields held close to all-time lows on Thursday.

Germany's 10-year government bond yield breached the ECB's deposit rate of -0.40%, a level which analysts say acts as a psychological barrier, despite shorter-dated German bond yields already trading well below the depo rate..

Spain sold 3.466 billion euros of new bonds on Thursday, while France also sold 10 billion euros of bonds.

The U.S. 30-year Treasury yield fell to its lowest since 2016, below the Fed Funds target rate, bringing the entire U.S. Treasuries curve under the Fed's main policy rate.

(Reporting by Virginia Furness; Editing by Catherine Evans and Andrew Cawthorne)