March 14 (Reuters) - Euro zone borrowing costs edged up

on Thursday as investors digested U.S. stubborn core inflation

data, while the yield gap between Italian and German bonds hit a

new 26-month low.

Investors keen on locking in returns close to the highest

levels in over a decade and increasing risk appetite supported

demand for Italy's BTPs. Bond prices move inversely with yields.

U.S. Treasury yields rose further on Wednesday as traders

speculated that sticky U.S. inflation may convince the Federal

Reserve to hold off cutting rates until after June, the

timeframe currently priced in by markets.

The yield spread between Italian and German 10-year

government bonds was last at 121 basis points

(bps) after hitting 120.30, its lowest level since mid-January.

Investors closely watch the spreads' tightening across bond

markets as they put aside concerns about Italy's budget deficit

and reckoned that a resilient economy will control the critical

debt-to-GDP ratio.

"The narrative from last week has not really changed, and

BTPs still look cheap compared to broader iBoxx," Citi said in a

note to clients.

iBoxx indices are based on the average values of government

bonds, sub-sovereigns, collateralized and corporate bonds.

"We continue to see tightening as more likely than widening,

towards 100-110 bps for 10-year BTP-Bund, but wait for better

entry levels for new longs," it added.

Italy's budget deficit was far higher than targeted last

year, but its public debt still fell thanks to strong inflation

and higher-than-expected economic growth, data showed on Friday.

"As even the budget deficit figures interrupted the spread

tightening only for one day, a global risk reversal would

probably be needed to turn things around," said Hauke Siemssen,

rate strategist at Commerzbank.

"Yesterday's ECB announcements did nothing to counter the

solid BTP spread tightening trend, which remains driven by the

hunt for carry," Siemssen said, referring to the European

Central Bank's operational framework review.

Germany's 10-year yield, the benchmark for the

euro zone, was last up 2 bps at 2.37%.

Investors await U.S. economic data later in the session.

After consumer prices increased solidly and job growth

accelerated in February, investors will look for additional

signs of resiliency from the U.S. economy.

The ECB wants to wean banks off free cash but will try to do

so gently enough not to upset the financial system or lending,

as the result of its long-awaited Operational Framework Review

showed on Wednesday.

"This outcome largely aligns with market expectations for a

demand-driven floor system with practically no impact in the

near term, especially since the ECB decided to leave the minimum

reserve requirement unchanged," said in a research note Carsten

Brzeski, global head of macro at ING.