UPDATE 1-Italy's borrowing costs tumble on expectations Draghi will become next PM

(Updates with comment, context, chart)

LONDON, Feb 3 (Reuters) – Italy’s borrowing costs fell on Wednesday, narrowing the gap over its German counterparts, after Italian President Sergio Mattarella looked set to ask former European Central Bank chief Mario Draghi to form a government of national unity.

The Italian head of state summoned Draghi for talks at 1100 GMT after hearing that efforts to salvage the collapsed coalition of Prime Minister Giuseppe Conte had failed.

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

In early trade, Italy’s 10-year bond yield tumbled 8 basis points to around 0.58%, its lowest level in almost two weeks. It was set for its biggest one-day fall since mid-January.

The gap between Italian and German 10-year bond yields narrowed to 104 bps from 113 bps late Tuesday.

“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.”

It was not initially clear which parties in the fractured parliament would support an administration headed by Draghi, who led the ECB during the euro debt crisis.

Aggressive bond-buying stimulus by a Draghi-led ECB helped narrow peripheral bond spreads sharply.

“Barring major surprises, it is very likely that a government led by Draghi, who enjoys strong bi-partisan support, would command a large enough majority in parliament to take office,” Federico Santi, senior analyst for Europe at the Eurasia Group, said in a note.

“Failure to do so would likely prompt a fresh attempt at fashioning a new government out of the outgoing coalition rather than snap elections, which remain a last resort.”

Other 10-year euro zone bond yields were a touch higher on the day — reflecting a more upbeat tone in world markets and lower Italy risks. Germany’s 10-year bond yield rose to -0.465% — its highest level since Jan 12.

Focus was expected to turn to euro zone inflation numbers for January late in the day.

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