September 5, 2018 / 7:54 AM / in 2 months

Italy's bond yields extend fall on EU-friendly budget remarks

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr

By Virginia Furness

LONDON, Sept 5 (Reuters) - Italian bond yields extended falls on Wednesday after its government moved to reassure investors that EU fiscal rules would be respected. But with budget talks scheduled today, analysts are awaiting further direction, which may affect yields further.

Elsewhere European Central Bank chief economist Peter Praet is speaking in Vienna which may offer some indication of the content of ECB talks next week. Eurozone bond yields were around one to two basis points lower in early trade.,

Investor concerns that increased government spending will see Italy breach European Union fiscal rules have kept Italian yields high. But senior government officials have moved to reassure the buyside this week, resulting in a fall in bond yields which saw the five-year reach a two-week low, pushing Italy’s 10-year yield spread over Germany to reach its narrowest point since Aug. 10.,

Deputy Prime Minister Matteo Salvini said on Tuesday that the government will try respect EU fiscal rules and honour pre-existing budget commitments, an apparent turnaround by the leader of Italy’s League who has previously pushed for budgetary expansion.

Sources told Reuters on Tuesday that Salvini is pushing for the government to accept a budget deficit “a bit above” 2 percent of output next year, and Economy Minister Giovanni Tria wants to keep the 2019 deficit below 2 percent of gross domestic product, sources familiar with the budget talks said on Monday.

Italy’s government is due to meet later for another round of budget talks, which may give further indications about deficit targets.

But an important question for investors is whether increased budgetary discipline is enough to save Italy from further ratings downgrades, says ING rates strategist Martin van Vliet. Ratings agency Fitch cut Italy’s outlook to negative from stable, although it kept its credit rating at BBB.

“Maybe the deficit target is not sufficient to stop the agencies pulling the trigger,” he said. “If growth slows next year, Italy could be downgraded, leaving aside the deficit. If we have a downgrade by just one notch, that could prompt foreign investors to possibly throw in the towel.”

Italy’s government bond spread over Germany fell to 257 bps, its narrowest since Aug. 10, but it still remains elevated at some 50 bps above recent lows in July, and 150 bps wider than pre-election levels.

“Italy is reversing some underperformance but the scope for spreads to tighten to levels seen before May is limited,” said van Vliet. “We are in a new regime and spreads are structurally higher than May.”

Should the ratings agencies now downgrade Italy, and if the budget deficit is around 2 percent, van Vliet said spreads could tighten to the 200 bps - 250 bps range.

Elsewhere, Germany’s government bond yields were flat to one bps lower, with its 10-year at 0.35 percent. (Reporting by Virginia Furness, editing by Louise Heavens)

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