UPDATE 3-Southern European bond yields tumble on EU recovery fund proposal

* Spanish, Portuguese yields down heavily at 6, 7-week highs

* Italian yields fall further, 10-year below 1.6%

* Banks forecast further spread tightening (Updates prices)

By Tommy Wilkes

LONDON, May 19 (Reuters) – Southern European government bond yields fell heavily on Tuesday after France and Germany proposed a 500 billion euro ($547 billion) recovery fund offering grants to regions hit hardest by the coronavirus pandemic.

Spanish and Portuguese yields led the move lower after a big drop in Italian yields on Monday.

France and Germany said on Monday that, as well as the recovery fund, they were proposing to allow the European Commission to borrow money on financial markets in the European Union’s name while at the same time respecting the bloc’s treaties.

The proposals already face opposition from wealthier EU members that want the fund to offer loans rather than grants.

The inclusion of grants in the proposal boosted Italian bonds because there have been growing concerns over whether the country’s mountain of debt would be sustainable without outside help in funding recovery from the pandemic’s economic fallout.

“These represent positive surprises which, in combination with the signalling effect of France and Germany jointly promoting the plan, we think has short-circuited spread widening for now,” Goldman Sachs economist George Cole said in a note.

Morgan Stanley economists said the proposal was a “powerful common response, helping to mitigate the risk of a southern slump”.

The Spanish 10-year yield was set to close the day down nine basis points (bps) at 0.72%, after touching its lowest since April 1 earlier in the session.

Portuguese bond yields declined to their lowest since March 31, down 14 bps on the day at 0.764%, before closing at 0.77%.

Italian yields fell across maturities. The 10-year yield fell 9 bps to 1.599% at one point, its lowest since April 9, before rising again to 1.65%.

Borrowing costs for Italian 10-year debt were trading above 2% as recently as two weeks ago.

Goldman Sachs forecast a further narrowing in the difference between Italian and German 10-year yields to less than 180 bps , which on Tuesday had fallen to 210 bps, as well as in the gap between Spanish and German yields.

German yields were slightly higher on the day, with the 10-year bond at -0.46%.