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UPDATE 2-Italy leads euro zone bond rally as markets bet coronavirus will keep ECB dovish

Dhara Ranasinghe

keep ECB dovish@

* EZ bond yields tumble, BTP yields hit 4-month lows

* Coronavirus worries fuel ECB rate-cut speculation

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

LONDON, Feb 13 (Reuters) - Italy led a rally in euro zone bond markets on Thursday, with 10-year Italian bond yields hitting four-month lows on growing confidence the ECB will keep monetary policy easy for longer to protect the economy from the fallout of coronavirus.

Bond yields across the bloc tumbled after the Chinese province at the epicentre of the coronavirus outbreak reported a record rise in the death toll under a new diagnostic method, that effectively lowers the bar for classifying new infections.

World stocks slipped, U.S. Treasury yields fell and the euro hit its lowest level against the Swiss franc since August 2015, setting the tone for euro zone bond markets.

Italy's 10-year bond yield tumbled as much as six basis points to around 0.86%, narrowing the gap over safer German Bund yields to around 125 basis points -- levels last seen in May 2018, just before a political crisis in Italy sparked a sharp sell off in its debt.

The bond rally eased later in the session following UK government bond yields, which rose after finance minister Sajid Javid resigned and his replacement, Rishi Sunak, was expected to pave the way for a more expansionary budget next month.

Italy's 10-year yield was down 2 basis points at 0.90% in late trade.

Germany's benchmark 10-year Bund yield was last down 1 basis point at -0.39%.

Analysts said higher-yielding southern European bonds were benefiting from a growing perception that the European Central Bank was likely to maintain a dovish monetary policy stance for much longer than previously anticipated given the coronavirus outbreak.

Greece's 10-year bond yield, which fell below 1% for the first time on Wednesday, extended falls to touch a fresh record low of 0.925%.

Citigroup's economic-surprise index for Europe has slumped to a four-month low and a sense that the U.S. economy will prove more resilient than the euro zone's in the face of coronavirus has hurt the euro.

"We are very bullish on the BTP spread because the ECB will keep monetary policy easy, so investors will need assets to invest in, especially ones with a positive yield," said Mizuho rates strategist Peter McCallum.

Italy's cost of funding fell to new record lows at auction on Thursday, while credit rating agency Moody's said the risk of early elections and of an exit by Italy from the euro have decreased under the coalition government led by the centre-left Democratic Party and the anti-establishment 5-Star Movement.

In a further signs that concern about the growth outlook is rising the five-year, five-year breakeven forward - a gauge of the market's long-term euro zone inflation expectations - fell below 1.22% to its lowest since early December.

"Expectation of more ECB support may well continue to help sentiment, but pricing of imminent easing has not gained much traction," said Benjamin Schroeder, senior rates strategist at ING.

"More importantly, looking through the Covid-19 (coronavirus) outbreak reveals a picture of the economic outlook that still does not look pretty." Investor morale in the euro zone fell for the first time in four months in February over fears that China will not be able to contain the coronavirus outbreak, a survey showed on Monday.

(Reporting by Dhara Ranasinghe, additional reporting by Yoruk Bahceli; editing by Larry King, Angus MacSwan and Alexandra Hudson)