UPDATE 2-German yield curve steepens, Italian bonds outperform on outlook upgrade

(Updates prices)

By Yoruk Bahceli

Oct 25 (Reuters) - Germany's yield curve steepened on Monday, while Italian bonds outperformed after an unexpected credit rating outlook upgrade.

Germany's 30-year government bond yield rose 1 basis point, while short-dated yields fell and its 10-year yield, the benchmark for the euro area, was down 2.5 bps at -0.12% by 1521 GMT , tracking moves in U.S. Treasuries.

The biggest move in the yield curve was the gap between the 5- and 30-year German bond yields, which widened 5 bps to 71 bps.

Developed market bond yields have risen in recent weeks, driven by accelerated bets on rate hikes from the Bank of England and U.S. Federal Reserve and concerns that high inflation may be less transitory than expected.

However, that has also seen yield curves flatten with longer-dated bond yields falling. That usually signals caution about the economic outlook and some analysts took it as a sign that markets think central bank reaction to rising inflation may be a policy error that could stifle growth.

"I would say also for this week and for the upcoming trading days that still inflation dynamics will play a major role," said Sebastien Fellechner, rates strategist at DZ Bank.

"Overall I would expect more steepening of the curves because of inflation as a market driver."

The curve steepened even as Germany's Ifo institute's business climate index fell to a six-month low in October due to supply problems and its central bank said German growth would slow sharply in the final months of this year.

European Central Bank policymaker Pablo Hernandez De Cos said recent developments are likely to prompt a "significant downward" revision of the ECB's 2021 outlook.

He also said the longer inflation pressures, currently seen as transitory, last, the likelier high inflation will become persistent.

Italian bonds outperformed after S&P Global revised the outlook on the country's BBB credit rating – two notches above junk – to positive, suggesting it could eventually upgrade it.

The agency cited the Italian government's progress in implementing reforms, which it expects will boost economic growth, as well as the ECB's pandemic-era monetary policy, which it said has also supported an investment-led recovery in Italy.

Italy's 10-year yield was down 4.5 basis points to 0.92%, pushing the closely watched gap with German peers down to 103 bps.

"This should be positive for the BTPs-Bund spread, despite that the spread is very tight and has been remarkably stable," said Jens Peter Sorensen, chief strategist at Danske Bank.

In the primary market, the European Union raised 2.497 billion euros from the re-opening of a seven-year bond at auction.

Net issuance turns sharply negative this week. Commerzbank expects around 18 billion euros of euro zone government bond issuance, but said the market will see nearly 80 billion euros of backflows from coupon payments and maturing bonds. (Reporting by Yoruk Bahceli; Editing by Alison Williams)