August 31, 2018 / 7:35 AM / 8 months ago

Italy's bond market steadies before ratings test

* Italy in focus ahead of Fitch review

* Italian/German yield gap close to highest since 2013

* Euro zone flash CPI due

* Euro zone periphery govt bond yields

By Dhara Ranasinghe

LONDON, Aug 31 (Reuters) - Italy’s battered bond market steadied on Friday before a Fitch Ratings review, in the spotlight given heightened concerns that the government’s spending plans will put further strain on already high debt levels.

While most bond yields across the euro area crept up in early trade, Italian borrowing costs edged lower following a sharp selloff late Thursday as turbulence in emerging markets sparked a broader selloff in risk assets.

Fitch Ratings is expected to release its review after markets close. It rates Italy BBB with a stable outlook.

Analysts say a ratings downgrade on Friday is unlikely given that the coalition government that came to power almost three months ago has yet to detail its spending plans. They did not rule out a cut in the outlook to negative, however.

Last week, ratings 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.”

Italy’s 10-year bond yield dipped one basis point to 3.20 percent, off three-month highs hit the previous day.

The gap over benchmark German Bund yields was at 284 bps, having reached around 288 bps on Thursday — the widest since July 2013.

Two and five-year Italian bonds yields also held near three-month highs hit on Thursday.

A coalition between the far-right League and anti-establishment 5-Star Movement plans to raise spending and cut taxes, raising concern about debt sustainability and setting up a potential clash with European Union rules on fiscal discipline.

EU Commissioner Guenther Oettinger chided Italy on Friday about its high debt levels - the second highest in Europe behind Greece - and said market confidence could be eroded if Europe raised its overall debt.

The EU expects a “substantial effort” from Italy on its upcoming budget law, European Commissioner for Economic and Financial Affairs Pierre Moscovici told financial daily Il Sole 24 Ore.

Uncertainty about Italy’s 2019 budget has put Italian bonds under renewed pressure with 10-year yields set to end August up more than 45 bps.

Focus was expected to turn to the flash estimate of euro zone inflation later on Friday.

Reporting by Dhara Ranasinghe; editing by John Stonestreet

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