* Graphic: World FX rates in 2018 tmsnrt.rs/2egbfVh
* Italian 10-year bond yield hits 4 year high
* Italian-German spread hits 5-1/2 year high
* Euro recovers after falling to 2-mth low on Italy worries
* MSCI ACWI set for longest losing streak since 2015
By Ritvik Carvalho
LONDON, Oct 19 (Reuters) - Investors shed Italian bonds on Friday, driving their yields to 4-year highs while the euro fell to a 2-month low as the European Union called Rome’s draft budget an “unprecedented” breach of EU fiscal rules.
U.S. stocks were set for a higher open, however, as a handful of major U.S. corporations beat results forecasts, offsetting concerns about political and growth risks in Europe, China and Saudi Arabia.
Late on Thursday, the European Commission told Italy that planned government spending was too high, its structural deficit would rise instead of fall and public debt would not fall in line with EU rules.
Italy is the third-largest economy in the 19-country euro zone, and a crisis there could unsettle the entire bloc.
While it isn’t unusual for the EU to ask member countries for clarification on points of their budget plans, the sending of a formal letter and the tone of the comments were particularly strong, analysts said.
“The letter was more sharply worded than usual. It described the budget as ‘an obvious deviation’ from prior commitments, on an ‘unprecedented’ scale,” Deutsche Bank research strategist Jim Reid said in a note to clients.
Top euro zone officials insisted Italy’s budget plan did not pose a “Greek-like” threat to European financial stability, but the row nonetheless led money market investors to start pushing back expectations for the timing of a European Central Bank rate rise.
Italy’s benchmark 10-year bond yields rose to 3.74 percent in early trade on Friday, the highest since February 2014. They last traded at 3.71 percent.
Italian stocks fell 0.7 percent, while its bank stocks were last down 2.2 percent.
The budget dispute initially weighed on the euro, which fell to a two-month low, before recovering by afternoon trade in Europe, last up 0.2 percent on the day.
The closely watched Italian/German bond yield spread hit a fresh 5-1/2 year high of 338 basis points.
Portuguese and Spanish bonds, that have been resilient so far through the Italian budget worries, were also sold, with several analysts suggesting that this was the first sign of contagion from Italy.
Analysts at MUFG said that if BTP (Italian government bond) yields moved notably higher “correlations could well strengthen and this would provide further downside pressure for the euro”.
Stock markets all round were a bit lacklustre: data showing China’s economy growing at its slowest pace since 2009 weighed on shares in Asia, although Chinese shares staged a recovery after the securities regulator announced a series of measures to aid the market.
MSCI’s broadest index of Asia-Pacific shares outside Japan was up 0.2 percent after earlier falling as much as 0.9 percent ahead of the China GDP reading.
Australian shares fell 0.05 percent and Japan’s Nikkei average ended 0.6 percent lower for its third straight week of declines.
Stocks in Europe managed a modest rise at the start of trading, but fell back into the red. The pan-European STOXX 600 index was down 0.1 percent.
The MSCI All-Country World Index, which tracks shares in 47 countries, was down 0.1 percent on the day. It was set for a fourth weekly loss on the trot, which would make it its longest weekly losing streak since the end of 2015.
1609 out of 2767 stocks on the index are in a bear market (58 percent of the total), up from 1557 last week, Bank of America Merrill Lynch said in a note on Friday.
In currencies, the dollar index, a gauge of the greenback’s value against major peers, was 0.1 percent lower at 95.863.
Meanwhile, the British pound rose after EU negotiator Michel Barnier said a Brexit deal with the United Kingdom was 90 percent done although hurdles remained.
Oil prices ticked higher after falling on Thursday. U.S. crude was up 0.6 percent at $69.04 a barrel and Brent crude was trading at $79.94 per barrel, 0.8 percent higher.
Spot gold gained 0.3 percent to $1,227.55 per ounce. (Reporting by Ritvik Carvalho; Additional reporting by Abhinav Ramnarayan, Tom Finn and Helen Reid in London; Editing by Toby Chopra)