Wed Oct 29, 2014 7:00am EDT
* Investors relieved as 2015 budgets pass muster
* Strategists say Italy-Spain yield gap justified
* Auction, bank worries still weigh on Italy's bonds
* Volumes low ahead of landmark U.S. Fed announcement (Adds comments, updates prices)
By John Geddie
LONDON, Oct 29 (Reuters) - Italian government borrowing costs edged lower on Wednesday, spearheading a rally in low-rated euro zone bonds, after the European Commission gave a provisional thumbs-up to Rome's 2015 budget.
Italy, like France, has been at loggerheads with Brussels over its push for greater fiscal flexibility in order to nurture fragile economic growth.
Strategists said the European Commission's announcement late on Tuesday that no euro zone states had submitted deficit plans that breached EU rules brought relief to investors.
"In an environment like this where we are lacking demand, there are more and more doubts about Germany's austerity-driven stance," said DZ Bank strategist Christian Lenk.
"The market appears more open to giving these countries some room to breath."
Ten-year Italian yields dropped 4 basis points to 2.50 percent, outpacing Spanish equivalents which dropped 1 bps to 2.15 percent.
But some remained uncertain as to whether Italy could close the yield gap further on Spain. The 10-year spread hit 40 bps this week - its highest since February 2012.
"I was in the camp of spreads going flat between Italy and Spain at the beginning of the year, but over recent months the data flow has really changed," said UniCredit rate strategist Luca Cazzulani, predicting the 10-year spread would remain between 30-40bps.
Spain's economy grew by 1.2 percent year-on-year in the second quarter, while Italy's contracted by 0.2 percent. Spanish third-quarter GDP data is due on Thursday with Italy's to follow in mid-November.
Diminishing prospects of a sovereign bond-buying programme from the European Central Bank have refocused investor attention on economic divergence in the euro zone, with bankers reporting a pick-up in relative value trading between member states.
In the near-term, a sale of five- and 10-year bonds from Italy on Thursday will likely stem any further fall in yields.
Investor appetite for Italian debt also remains tempered by questions over its banking sector after the country fared the worst in the ECB's stress tests.
Italy's Monte Paschi may seek to delay repaying hundreds of millions of euros in state aid to help shore up its balance sheet.
Elsewhere in the periphery, Greek 10-year yields fell 6 bps to 7.51 percent, while Portugal's were 2 bps lower at 3.35 percent.
In France, where there had also been concerns about its budget negotiations, 10-year yields fell 2 bps to 1.26 percent .
Strategists said the price action had been slightly exacerbated by low volumes with many investors sidelined ahead of a U.S. Federal Reserve policy decision later on Wednesday.
At the conclusion of its two-day meeting, the Fed is expected to announce the end of its bond-buying stimulus while restating its willingness to wait before hiking interest rates.
"In our view, any major tightening of monetary policy remains a story for the latter half of 2015," said Nick Gartside, CIO for fixed income at JPMorgan Asset Management.
"We think the Fed will remain keen to defuse any large scale market turmoil in the immediate term and will continue to focus on language that helps to stabilise the markets."
German 10-year bond yields - the benchmark for euro zone markets - were up 1 bps at 0.88 percent after another weak German auction of 10-year paper. (Editing by Alison Williams and Nigel Stephenson)
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