(Updates prices) LONDON, Nov 2 (Reuters) - Italy led a recovery in euro zone bond markets on Tuesday, with borrowing costs falling sharply as fears over higher inflation and interest rates subsided for now. Bond yields across the bloc have shot up since European Central Bank chief Christine Lagarde disappointed investors last week by not pushing back more firmly against aggressive market pricing of interest rate rises next year — a view that is at odds with ECB policy guidance. But a calmer tone took hold, with analysts citing the outcome of an Australian central bank meeting as one trigger. Australia’s short-dated bond yields and the Aussie dollar fell sharply after the Reserve Bank of Australia took a major step towards unwinding extraordinary pandemic stimulus but pledged patience and rejected market talk of an early rate hike. Southern European bonds, which bore the brunt of the selloff in the wake of last Thursday’s ECB meeting, outperformed. Italy’s 10-year bond yield, for instance, slid 14 bps to 1.08%, off more than one-year highs touched on Monday. It was set for its biggest one-day fall since May 2020, according to Refinitiv data. “We are oscillating between two views on rate hikes with markets swinging between ‘hikes on’ and ‘hikes off’ mode,” said ING senior rates strategist Antoine Bouvet. “Today we’re in a bit of a ‘hikes off’ day because of the RBA,” he said. Bouvet added that bond markets had become more volatile as investors tried to assess the outlook for inflation and interest rates, with the range of possible outcomes much wider than in the past. Spanish and Portuguese 10-year bond yields tumbled 8-9 bps each , having also jumped in recent days as peripheral markets woke up to the risk that the ECB could tighten policy faster than anticipated. Meanwhile, a key market gauge of long-term euro zone inflation expectations dropped back below 1.9% for the first time in two weeks, having shot above 2% last week. Germany’s 10-year Bund yield, which rose 10 bps in October, fell 6 bps on the day to -0.16%. It held below roughly 2-1/2 year highs hit last week at -0.065% and it was set for its biggest one-day fall in four months. The sharper drop in Italian yields squeezed the gap over safer German peers to around 124 bps after it widened to around 135 bps on Monday — the widest in a year. “We think the widening of periphery spreads and in particular of the BTP-Bund spread has been too sharp and too quick,” UniCredit analysts said in a note, adding that they expected spread tightening in the next few weeks, given Italy’s positive economic outlook and the ECB’s ongoing bond buying stimulus. “Undeniably, the chance of high volatility in the rates universe continuing to prevail in the next few days is sizeable, making it tricky to guess the best entry point for a BTP-Bund tightening trade,” the UniCredit note said. Reporting by Dhara Ranasinghe; Editing by Krishna Chandra Eluri