Lukewarm demand at an Italian bond auction on Tuesday threatened to push the euro zone's third largest economy back to the centre of the crisis, while disappointing US data gave core fixed income markets an additional bid.

"This week's data is crucial, especially in the US," said Nick Stamenkovic, rate strategist at RIA Capital Markets. If we see more very weak data, the market will fear recession is looming and risk markets will come under renewed pressure and Bunds can test their recent lows in terms of yields."

Focus is also on Spain's sale of up to 4 billion euros of five-year bonds on Thursday.

"Italy was disappointing yesterday and there's a risk of the same for Spain, although the market is factoring that in already," a trader said.

Italian 10-year government yields -- which had edged below 5 percent with the European Central Bank buying in the secondary markets -- were at 5.15 percent, their highest since the ECB began its action more than three weeks ago.

"Even a slow, controlled rise in BTP yields, while preferable to the situation earlier this month, is enough to send end-buyers scurrying away form the periphery, given the horrible time they've had over the past 18 months," said Credit Agricole rate strategist Luca Jellinek.

September Bund futures were 26 ticks lower at 135.02. Despite retreating from record highs above 136.00, the contract is up around 5 points since the start of August, reflecting fragile sentiment over the euro zone crisis and fears of slowing growth in the region and globally.

Meanwhile, riskier assets have put in a dismal performance with the FTSEurofirst index of European shares on track for its worst month since September 2002 and European banking stocks their biggest monthly drop since October 2008.

"People have been taking risk off and are on the sidelines evaluating the markets," the trader said. "But Bunds are still well supported and we should continue to see buying on dips."

German 10-year yields were up 2 basis points at 2.14 percent but on track for their biggest monthly fall in percentage terms since September 2010.

Investors' search for yield at the longer end of the maturity spectrum has flattened the curve by 15 basis points in the last two weeks.

Minutes of the US Federal Reserve's August meeting published late on Tuesday boosted expectations for more stimulus while data showed a plunge in consumer confidence, a further worrying sign for the economic outlook.

U.S DATA

A weaker-than-expected number in US private sector employment data on Thursday could see further flows into core government bond markets, with US Treasuries outperforming.

The 10-year spread between higher-yielding Treasuries and German Bunds has narrowed back close to zero over the last week, from around 12 basis points, as the US paper has outperformed on disappointing data and stimulus hopes.

Flash August euro zone inflation data is due at 0900 GMT and seen steady from the previous month at 2.5 percent. ECB President Jean-Claude Trichet said earlier this week the central bank was reviewing the risks to price stability.

"Unless there were to be a sizeable turnaround ahead of next week's Governing Council meeting then... there is likely to be a shift in inflation language at this meeting, thus going some way to meet recent euro policy rate expectations," Lloyds Bank strategists said.

Markets have priced out expectations of further rate hikes, even beginning to price in a rate cut towards year-end.