UPDATE 1-Italy-Germany gap at its lowest in 5 years on Draghi effect

adds details, context, updates prices,

By Sara Rossi

MILAN, Feb 5 (Reuters) - Italy's 10-year bond yield headed for its biggest weekly drop since July on Friday, while the gap over the German Bund yield narrowed to its lowest in five years as former European Central Bank chief Mario Draghi began talks to form a new government.

Trade in euro zone debt markets was generally subdued before January U.S. payrolls data at 1330 GMT. Global shares approached record highs as progress in vaccine distribution and U.S. stimulus hopes prompted bets on further normalisation in the global economy. nL1N2KB0JM

That backdrop boosted sentiment towards risk assets such as peripheral European bonds, with Italy set to end the week on a high note following this week's political developments.

Draghi, given a mandate to form a new Italian government, will end a round of consultations on Saturday. It is still unclear whether he can win the support of the anti-establishment 5-Star Movement, the largest party in parliament. nL1N2KA183nL8N2KB1V5

Italy's 10-year BTP, or government bond, yield IT10YT=RR fell around 2 basis points to 0.531%, after touching its lowest level since Jan. 11. It is down almost 12 bps this week.

The Italian/German 10-year yield spread fell to around 94 basis points, its lowest level since early 2016 DE10IT10=RR.

"We've seen how the market doesn't just like Draghi, it loves Draghi and foreign investors are supporting the rally in BTPs," said MFS fixed-income research analyst Annalisa Piazza.

Piazza said room for further spread tightening was limited although Italy could see further outperformance over euro zone peers if a Draghi government successfully implemented his programme in the medium term.

"Markets are pricing in a government led by Draghi. But even if the former ECB head were unable to form a government, we would see a sell-off in the short term that would translate however into a compression of interest rates in the long term," said Althea Spinozzi fixed income strategist at Saxo Bank.

UniCredit analysts added that further spread compression in Italy would likely depend on two factors:

"1. the extent of parliamentary support the government will enjoy and 2. foreign investors' willingness to increase their exposure to the BTP market again," they said in a note. "The 2015 lows of 88 bps for the 10Y BTP-Bund spread do not seem to be out of reach."

News of a fall in German industrial orders in December put brief downward pressure on German yields in early trade. nL8N2KB1KV

But Bund yields soon headed higher again, touching their highest level since September at -0.436% DE10YT=RR and set for the biggest weekly jump since August.

Focus is on U.S. payrolls data, with economists polled by Reuters forecasting an increase of 50,000 new jobs after a decline of 140,000 in December. nL1N2K92L7

(Reporting by Sara Rossi, additional reporting by Dhara Ranasinghe; editing by Kirsten Donovan)

((sara.rossi@thomsonreuters.com; +39 06 8030 7736;))