Italy’s bond yields drop ahead of S&P rating review

* IHS Markit's flash Composite Purchasing Managers' Index at 49.4

* Peripheral yields lower across the board

* ECB expected to extend QE by year end

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates prices, adds latest news and chart)

By Abhinav Ramnarayan and Stefano Rebaudo

LONDON/MILAN, Oct 23 (Reuters) - Italian government bond yields were lower on Friday as investors seemed confident that a downgrade on Italy's rating is not imminent and after business surveys showed the extent of the economic impact of the second wave of COVID-19. Euro zone economic activity slipped back into decline this month, heightening expectations for a double-dip recession as governments reimpose activity-dampening restrictions to stem the pandemic, surveys showed on Friday.

"It's not surprising given the local restrictions imposed in major cities in France and elsewhere, and the majority of investors are expecting more action from the ECB by the year end," said Commerzbank rates strategist Rainer Guntermann.

Yields on Italian 10-year bonds, known as BTPs, dropped 4.2 basis points to 0.76%. Other peripheral countries followed, with Spain's 10-year bond yield down 2.6 basis points at 0.20% and Portugal 10-year down 2.5 basis points at 0.18%.

S&P is scheduled to publish a review of its rating on Italy late on Friday.

Italy has registered 19,143 new coronavirus infections over the past 24 hours, the health ministry said on Friday, the highest daily tally.

"Today BTPs are strong, supported by expectations of no change in the S&P rating after this week's correction," Anna Guglielmetti, head of institutional portfolio management Italy at Credit Suisse said.

"BTPs showed a strong rally recently as ECB measures mainly affected peripheral government bonds. But I think that for a further rise we will have to wait for more stimulus from the ECB."

According to Unicredit, however, "if the rating agency announces no change in both rating and outlook (our baseline), BTPs might rally, with the 10Y BTP-Bund spread possibly coming back towards the 125 basis points area.

"Should S&P downgrade Italian government bonds by one notch (from BBB to BBB-), the spread might widen towards the 150 basis points area," its research note added.

The closely watched Italy-Germany bond yield spread was at 132.8 basis points.

German 10-year bond yields, the benchmark for the bloc, were flat at -0.57%.

"Bunds are struggling to hold on to the -0.60% level despite sluggish risk appetite," a Commerzbank research note says.

Analysts also expected the European Central Bank to announce an extension of its asset purchase programme (PEPP) by the end of the year and a more flexible application of it.

(Reporting by Abhinav Ramnarayan and Stefano Rebaudo; Editing by Christopher Cushing and Alex Richardson)

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