(Recasts headline, lead, adds analyst quotes, yield curve developments)
By Kate Duguid
NEW YORK, Oct 2 (Reuters) - The yield curve flattened on Tuesday as a hawkish afternoon speech from Federal Reserve Chair Jerome Powell lifted the short end of the curve while the long end remained muted as investors sought safety from the Italian bond selloff.
Powell on Tuesday hailed a "remarkably positive outlook" for the U.S. economy that he feels is on the verge of a "historically rare" era of ultra-low unemployment and tame prices. The situation, with below 4 percent unemployment expected through at least two more years, and inflation that will remain modest even as wages rise, would be "unique in modern U.S. data," Powell said.
The hawkish implication for interest-rate policy lifted the two-year note yield, which reflects market expectations of interest rates hikes. Although the speech boosted the two-year yield from a session low of 2.799 percent, it was last at 2.811 percent, below its open.
Yields at the long end of the curve, which reflect investors' view of the overall health of the economy, remained muted despite Powell's comments thanks to a risk-off move overnight after an Italian lawmaker cast doubt over Italy's membership in the euro, resulting in a sell-off in Italian government debt that sent investors seeking safe-haven bets.
The spread between two- and 10-year yields was 25.7 basis points at the open but fell to as low as 23.1 basis points on Tuesday afternoon.
The further flattening following Powell's speech showed "that even though globally there are more global risks than there were at the beginning of the year, he believes that the U.S. economy remains strong," said John Herrmann, director of U.S. rates strategy at MUFC Securities.
Italian 10-year bond yields soared to a 4-1/2-year high early on Tuesday after Italian lawmaker Claudio Borghi, economic head of the League party, said most of the country's problems would be solved by ditching the single currency, even as the government attempted to backtrack.
Yields at the long end of the U.S. curve had fallen by as much as 3 basis points after Italy defied pressure from Brussels and its euro zone partners to water down ambitious budget plans.
The U.S. 10-year yield was last at 3.056 percent and the 30-year bond yield was at 3.205 percent. The move erased a rise in U.S. yields on Monday following the negotiation of a trilateral free-trade pact between the United States, Canada and Mexico. (Reporting by Kate Duguid; Editing by Jonathan Oatis and Bill Trott)