By Dhara Ranasinghe
LONDON (Reuters) - Most euro zone bond yields fell on Friday, with German borrowing costs at three-week lows as turmoil in major emerging markets Turkey and Russia boosted demand for safe-haven government debt.
The exception was Italy. Its bond yields, already pushed up by concerns about upcoming budget talks, faced additional upward pressure as risk aversion gripped world markets.
Turkey's lira
Markets were also unnerved by a report in the Financial Times that the European Central Bank was worried about European banks' exposure to the country.
The ECB, which declined to comment on the report, is said to be chiefly concerned about Spain's BBVA (MC:BBVA), Italy's UniCredit (MI:CRDI) and France's BNP Paribas (PA:BNPP).
Shares in these banks fell more than 3 percent each, while the euro tumbled to its lowest levels in more than a year (EUR=).
"People looking at things this morning are much more aware that there is central contagion risk," said David Owen, chief European economist at Jefferies in London.
"Having said that, what's happening in EM (emerging markets)is leading to risk-free rates being bid for and that includes Treasuries, Bunds and gilts."
Most 10-year euro zone bond yields fell 2-3 basis points on the day.
Yields on 10-year German bonds, regarded as one of the safest assets in the world, hit three-week lows of 0.334 percent and were set for the biggest one-week fall in seven weeks.
U.S. and British 10-year bond yields fell to their lowest levels in almost three weeks (US10YT=RR) (GB10YT=RR).
"There is a clear safe-haven bid for bonds given concerns about the so-called bank-sovereign doom loop," said DZ Bank strategist Andy Cossor.
Berenberg European economist Carsten Hesse said in a note that while a full blow Turkish banking crisis would have some negative repercussions for euro zone banks with a large exposure to Turkey, the overall exposure of the euro zone banking sector seems too small to spark a "significant" euro zone crisis.
European stock markets fell 0.9 percent (STOXX). In addition to Turkey's woes, a slide in the Russian rouble this week on threats of new U.S. sanctions and nagging worries about a global trade war have jolted world markets.
Italian bonds felt the ripple effects as investors steered clear of risky assets, while domestic political worries also weighed on sentiment.
Italy should scrap a clause in its constitution obliging it to run a balanced budget, deputy Prime Minister Luigi Di Maio said, adding the government was not yet working on the matter.
Markets fear the big spending plans of the new anti-establishment coalition will push up Italy's already high debt levels and put it on a collision course with the EU and its fiscal rules.
Italian 10-year bond yields were up 5 bps at 2.95 percent (IT10YT=RR), pushing the gap over German peers to 260 bps from 253 bps late on Thursday.
Italian debt insurance costs hit the highest level in two months.