Wires

UPDATE 2-Euro zone bonds rally as U.S. warns of EU tariffs

Dhara Ranasinghe

* Euro zone bond yields fall, breaking streak of daily rises

* US/EU trade conflict adds to global growth worries

* Poor U.S. manufacturing survey furthers rally

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Adds analyst comment, Italy outperformance, record low inflation expectations)

LONDON, Oct 3 (Reuters) - Euro zone government bonds rallied for the first time in a week on Thursday in response to the United States' preparing to take action to impose tariffs on the European Union as well as U.S. service sector data that heightened recession fears.

A euro zone bond rally had stalled this week -- while U.S. Treasury prices shot up and yields tumbled -- as concern grew that the European Central Bank had limited room to boost growth and inflation. But as stock markets came under pressure, jittery investors turned back to safe-haven government bonds.

The United States on Wednesday said it would impose 10% tariffs on European-made Airbus planes and 25% duties on European products such as French wine as punishment for illegal EU aircraft subsidies.

This was followed by a purchasing managers survey, which showed U.S. services sector growth slowed to its most anemic pace in three years last month, and job growth in the largest slice of the American economy was the weakest in half a decade.

Ten-year bond yields across the euro area fell 4 to 7 basis points on the day .

Bond auctions in France and Spain were also followed by yield falls.

Germany's 10-year Bund yield fell to -0.59%, falling for the first time in more than a week. It was down 5 bps, set for its biggest one-day fall in a week and a half.

"We have been surprised by the uptick in bond yields in the past week, but the trend has been for lower rates given the package from the ECB," said Benjamin Schroeder, senior rates strategist at ING, referring to the ECB decision last month to cut rates and resume asset purchases.

"What has helped now from across the Atlantic was the weak data," he added.

On Tuesday, the Institute for Supply Management (ISM) said its U.S. manufacturing activity index fell in September to its lowest in a decade, fueling expectations the Federal Reserve would cut rates this month.

Until now, the rally in U.S. bonds has failed to spread to the euro zone, leaving the gap between short-dated U.S. and German bond yields at its tightest since late 2017, around 222 bps .

Meanwhile, inflation expectations for the euro zone fell to record lows, with the five-year, five-year breakeven forward tumbling below 1.12%, its lowest level ever

"Obviously the ECB is not going to be happy about it. They were probably quite happy the day after the announcement," said Societe Generale's head of inflation strategy Jorge Garayo, referring to an initial rise in inflation expectations following the ECB's stimulus announcement.

"Now we're back to the same levels again, so people will question whether they can influence that measure. We believe they probably cannot," he added, seeing monetary policy on its own as insufficient to influence pricing of the five-year, five-year breakeven forward.

Italian government bonds outperformed, with the 10-year benchmark yield down 6 bps to 0.84%, as the sovereign is one of the few remaining places where investors can find a positive yield in the euro zone government bond market.

Some 68.8% of euro zone government bonds have a negative yield, data as of end-September showed. This was the highest share on record but up just marginally from August.

(Reporting by Dhara Ranasinghe; additional reporting by Yoruk Bahceli Editing by Shri Navaratnam and Jane Merriman)