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UPDATE 1-Italy's bond yields tumble after auction success

Dhara Ranasinghe

* Italy's seven-year yields hit 20-month low at auction

* Fed's Powell sets stage for first U.S. rate cut in a decade

* Euro zone periphery govt bond yields (Rewrites to lead with move in Italian bonds)

LONDON, July 11 (Reuters) - Italy's borrowing costs tumbled on Thursday after an auction of short- and medium-term government bonds showed further evidence of strong demand for higher-yielding Italian debt.

Italy paid the cheapest seven-year yields in 20 months at the auction, thanks to demand from investors hunting for returns amid a sharp erosion in euro government yields - over half of which are below zero.

A sale of three-year Italian bonds was placed at 0.49%, more than halved compared with 1.05% at the previous auction in mid-June and the lowest since May 2018.

Thursday's bond sales follow a re-opening of a 50-year Italian bond for 3 billion euros on Tuesday that drew bids for more than five times that amount.

"Investors are still keen on a bit more buying in Italy despite the strong rally we've seen," said Natixis fixed income strategist Cyril Regnat. "When you look at how negative yields are on core government bond issuers, it makes sense to keep buying Italian bonds."

Italian yields fell 3 to 5 basis points across the curve , while most other euro zone bond yields were steady or higher on the day.

Italy's 10-year bond yield fell 4 bps to 1.68%, pushing the gap over German Bund yields back below 200 bps.

Italy last week dodged the threat of EU disciplinary action over its public finances after persuading the European Commission that new measures would help bring its growing debt into line with EU fiscal rules.

The country's bond market has also benefited from speculation the European Central Bank may soon begin new asset purchases to boost weak growth and inflation.

That backdrop has proved favourable for this week's bond sales.

Almost half way into July, Italy's 10-year bond yield is down some 40 basis points, compared with a 3 bps rise in Germany and a 2 bps decline in French yields.

"We have added exposure to Italian BTPs, which was a move driven by heightened expectations of QE being announced, for which Italian sovereign bonds have historically been a key beneficiary, and at a time when imminent EDP (excessive deficit procedure) risks on Italy have faded," said Mohammed Kazmi, a portfolio manager at UBP.

Most other euro zone bond markets were largely steady, after selling off on Wednesday following some upbeat economic news from France and Italy. They rallied after comments from Federal Reserve chief Jerome Powell set the stage for a U.S. rate cut this month.

Having posted its biggest one-day jump since April on Wednesday, Germany's 10-year bond yield was little changed at minus 0.30%. It is about 10 bps above last week's record lows.

Focus turned to the release of the European Central Bank's June minutes later this session and whether it has started discussions about a return to asset purchases.

(Reporting by Dhara Ranasinghe; Editing by Alison Williams, Larry King)