UPDATE 2-Euro zone peripheral yields drop, rating upgrade supports Italy

(Recasts, updates prices)

By Dhara Ranasinghe and Stefano Rebaudo

LONDON, Dec 6 (Reuters) - Euro zone periphery borrowing costs fell on Monday tracking moves in Italian bond market, which is outperforming its peers after a rating upgrade by Fitch.

Trading across the single currency bloc was generally subdued as investors awaited more details on the new Omicron coronavirus variant and what it means for the global economic outlook and European Central Bank policy.

Fitch Ratings late on Friday lifted Italy's sovereign credit rating by one notch to BBB, citing confidence in the economic outlook supported by the use of the European Union's post-pandemic recovery fund.

Italy's 10-year government bond yield -- which moves inversely with bond prices -- fell 4 bps, after hitting a two-week low at 0.873%.

"It's completely consistent with the positive fundamental picture that we have on Italy over the medium term, and in fact, it makes us even more confident that we will see further rating upgrades down the line," said Camille de Courcel, head of G10 rates strategy, Europe at BNP Paribas, referring to the Fitch ratings upgrade.

Portugal's and Greece's 10-year government bond yields dropped around 2.5 bps. Spain's borrowing costs are down 1.5 bps.

Italy's 10-year bond spread over Germany narrowed to 125 basis points from 130 bps late on Friday but remained about 15 bps wider than levels seen a month ago -- reflecting increased uncertainty priced into peripheral bond spreads over the ECB policy outlook.

The ECB may set policy for a relatively short period at this month's meeting, given heightened uncertainty, but should not delay a decision as markets need direction, ECB President Christine Lagarde told Reuters on Friday.

"We are bracing ourselves for quite a lot of market – and policy communication - volatility as we assess the severity of the Omicron variant, as the market may focus on incomplete data together with alternating encouraging or concerning 'soft' messages," AXA Group chief economist Gilles Moec said.

Germany's benchmark 10-year Bund yield was down 0.5 basis point at around -0.38%, despite a rise in U.S. Treasury yields as world stock markets staged a tentative rebound. The 10-year U.S. yield is up 6 bps at 1.4%.

Bond strategists expected issuance in the euro area at around 10 billion euros this week, winding down ahead of the year-end. Many of the bloc's issuers are also expected to unveil their issuance plans for the year ahead. (Reporting by Dhara Ranasinghe, additional reporting by Stefano Rebaudo; Editing by Alison Williams)