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UPDATE 1-Ten-year German govt bond yield dips to lowest in over six months

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* German 10-year bond yield hits six month low

* Italy two-year yield touches four month low

* Di Maio makes more soothing noises over budget

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Adds detail on European, Italian data, updates prices, adds quotes throughout,)

By Virginia Furness

LONDON, Dec 5 (Reuters) - Germany’s 10-year government bond yield fell to its lowest in over six months on Wednesday, feeling the effect of a flattening U.S. curve that is stoking fears of an economic downturn.

Risk sentiment is also being hurt by waning optimism over U.S. China trade talks and a series of setbacks over Brexit, all of which have combined to halt Monday’s global rally, which was driven by optimism over trade.

The gap between Germany’s two-year and 10-year bond yields narrowed further to 85.70 basis points, the tightest in 17 months, after parts of the U.S. Treasury yield curve inverted for the first time in over a decade, hinting at recessionary expectations.

European equities opened around 1 percent lower while the bid for safe-haven assets pushed Germany’s 10-year government bond yield, the benchmark for the region, to its lowest in six months at 0.242 percent, though it then pulled back slightly to 0.253 percent.

“There has been a huge flight to safety in the European bond market, but equities closed on Tuesday only modestly lower while there were sharp falls in the U.S.,” said Martin van Vliet, senior rates strategist at ING. “The European bond market was already preparing for trouble ahead.”

Other high-grade euro zone government bond yields were also around one basis point lower,.

Surveys showed Business growth in the bloc was at its weakest in over two years last month as a manufacturing-led slowdown showed further signs of spreading to the service industry.

More turmoil on the Brexit front is likely, after British Prime Minister Theresa May’s government was found in contempt of parliament and then a group of her own Conservative Party lawmakers won a challenge to hand more power to the House of Commons if her deal to leave the EU is voted down.

U.S. equity futures were firmer after China expressed confidence on Wednesday that it can reach a trade deal with the United States. However, U.S. President Donald Trump warned that he would revert to more tariffs if the two sides cannot resolve their differences.

U.S. markets are closed for a day of mourning for former president George H. W. Bush.

ITALY BONDS RALLY Italian government bond yields fell by up to nine basis points, with analysts unable to pinpoint a particular trigger for the move.

“The overnight news was on aggregate positive, and it looks more likely the Italian government will make a concession and target a smaller deficit,” said Peter Chatwell, rates strategist at Mizuho. “There are some technical factors as well.”

ING’s van Vliet said the rally in Italian bonds could also have been prompted by Spain’s strong sale of 3 billion euros ($3.4 billion) of debt at its final bond auction of the year on Wednesday.

Italy’s two-year government bond yield fell to its lowest since July, down 8.5 basis points at a low of 0.565 percent . It’s 10-year bond yield slipped 7.4 basis points to a two-month low of 3.076 percent.

Italian manufacturing data was more positive than expected, and deputy prime minister Luigi Di Maio reiterated that Italy wants to avoid disciplinary action over its 2019 budget, both of which could have provided fuel for the rally.

European Commissioner Guenther Oettinger added further pressure on Italy to lower its proposed budget deficit for 2019. He said even a deficit goal of 2.2 percent of gross domestic product “would be against all the commitments”.

Italy’s services sector returned to growth in November after contracting the previous month, a survey showed on Wednesday, beating forecasts and hinting at the possibility for growth in the fourth quarter.

Economy Minister Giovanni Tria said on Tuesday the government was weighing additional asset sales next year to cut debt, as it seeks to settle a dispute with the European Commission over the budget.

Reporting by Virginia Furness, editing by Larry King and Kirsten Donovan

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