Italy's short-dated bond yields hit their highest levels in almost three months on Friday, as remarks from an official that an EU budget ceiling could be exceeded if needed fuelled bearish sentiment towards debt markets ahead of a key ratings review.
Italy could exceed the European Union's 3 percent deficit ceiling next year if the extra spending is needed to make sure the country's infrastructure is safe, a senior government official said.
A coalition of the far-right League and anti-establishment 5-Star Movement plans to increase spending and cut taxes, raising concerns about Italy's debt sustainability and a potential clash with European Union rules on fiscal discipline.
"These comments provide yet another reminder that investors should be watching Italy and should be worried," said Chris Scicluna, head of economic research at Daiwa Capital Markets.
5-Star is pushing for a budget deficit next year that is triple the previous government's goal and near double the level Economy Minister Giovanni Tria is prepared to accept, Italian newspapers said on Friday.
Italy's government bond yields hit three-month highs across the curve with the two-year bond yield rising to 1.46 percent, up 12 basis points on the day. Five-year yields climbed to 2.58 percent and 10-year yields reached 3.25 percent, having reversed early falls. The 10-year yield was set to end August up more than 50 bps.
The gap over benchmark German Bund yields was at 291 bps.
Other euro zone bond yields were 1-2 basis points lower, perhaps in reaction to data showing inflation in the bloc eased to 2 percent in August from 2.1 percent in July.
Concerns about a spending binge in Italy, the euro zone's third biggest economy and one of its most indebted, have put the spotlight on the country's ratings outlook.
Fitch Ratings is due to release its latest review of Italy after the market close. It rates the country BBB, with a stable outlook.
Analysts say a Fitch downgrade is unlikely as the government has yet to detail its spending plans. They did not rule out a cut in the ratings outlook to negative, however.
Last week, rival agency Moody's said it was extending its review for a possible downgrade of Italian debt to gain "better visibility" on the fiscal path and reform agenda.
"There are several analysts saying that the market is priced for a ratings downgrade ahead," said Patrick O'Donnell, an investment manager at Aberdeen Asset Management.
"Our view is that the market is underpriced for the opening gambit of the budget talks. It looks like to us that you are going to get a pretty significant fiscal deficit and that may be negotiated back."
"In our view there is excessive bearishness around Italy and Italian spreads are pricing in too much euro break-up risk," said Mark Dowding, a senior portfolio manager at BlueBay Asset Management. He said he had been adding to an overweight position in Italian bonds in the past week.
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