UPDATE 2-Italy's bond markets set for best day since June on Draghi effect

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MILAN, Feb 3 (Reuters) – Italy’s borrowing costs fell sharply on Wednesday and were poised for their biggest daily fall since June after Italian President Sergio Mattarella looked set to ask former European Central Bank chief Mario Draghi to form a government.

A meeting between the head of state and Draghi was scheduled at 1100 GMT and Mattarella will almost certainly give him a mandate to put together a high-profile administration that he hopes will win the backing of a broad sweep of parties in the fractured parliament.

After weeks of political uncertainty, markets cheered the prospect of the trusted former central banker taking over at a time when Italy is grappling with a pandemic and its worst recession since the end of World War 2.

Italy’s 10-year bond yield tumbled 10 basis points to 0.55% , its lowest level in two weeks. It was set for its biggest one-day fall since June 2020.

That squeezed the closely-watched gap between Italian and German 10-year bond yields to 103 bps from 113 bps late Tuesday , the lowest level since mid-January.

German 10-yr bond yields meanwhile were around 1 bp higher on the day at -0.48%, hovering around the highest level since three weeks.

“The possibility of Draghi becoming the next prime minister of Italy has been welcomed by BTP investors. We expect more (spread) tightening to occur if Mr. Draghi is confirmed as prime minister, with the 100 bps mark easily within reach,” wrote UniCredit analysts in a note to clients.

“However, the outcome is still highly uncertain and BTP strength should be treated with caution as it is ultimately tightly linked to the political situation,” they added.

It was not initially clear which parties in the fractured parliament would support an administration headed by Draghi.

The former ECB chief is widely credited with pulling the euro zone back from the brink of collapse in 2012, pledging to do “whatever it takes” to save the euro.

“We understand the knee-jerk rally in Italian bonds as a result owes to a large part to the former ECB president’s name being associated with lower yields,” said ING senior rates strategist Antoine Bouvet.

“However, his success, and therefore the sustainability of this rally, depends on a broad agreement among political parties on the government’s agenda. M5S, the largest party in parliament, already said it opposes the idea.”

Elsewhere, markets showed little reaction to euro zone consumer inflation that rebounded by much more than expected in January, a flash estimate showed on Wednesday.

After a flurry of euro zone government bond sales on Tuesday, Portugal launched a new 30-year bond due April 2052 via syndication on Wednesday.

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