UPDATE 1-S&P cuts Italy ratings one notch, outlook negative
* S&P cuts Italy by one notch, may cut again
* Cites weak economy, political deadlock
* Euro skids, investors run to safety of Treasuries (Adds market, analyst reaction)
Sept 20 (Reuters) - Standard and Poor's downgraded its unsolicited ratings on Italy by one notch to A/A-1 and kept its outlook on negative, a major surprise that threatens to add to concerns of contagion in the debt-stressed euro zone.
The single currency skidded over half a cent to $1.3606 after S&P said the cut reflected its view of Italy's weakening economic growth prospects.
Italy's fragile governing coalition and policy differences within parliament will likely limit the government's ability to respond decisively to the challenging domestic and external macroeconomic environment, the agency said.
"In our opinion, the measures included in and the implementation timeline of Italy's National Reform Plan will likely do little to boost Italy's economic performance, particularly against the backdrop of tightening financial conditions and the government's fiscal austerity program," said S&P.
The move from S&P came as a surprise as the market had thought Moody's was more likely to downgrade Italy first. Moody's last week said it would take another month to decide on its action.
The downgrade came as Greece struggles to meet demands from lenders for yet more austerity measures.
"It's just more of the same negative news," said Stephen Roberts, a senior economist at Nomura in Sydney.
"It only adds to the contagion risk over Greece and has encouraged the flight to safety in markets here," he added, pointing to a sharp fall in the Australian dollar on the news.
S&P 500 futures SPc1 also dropped 0.7 percent and early hopes for a bounce in Asian shares on Tuesday looked to be still-born now.
European stocks had already slid on Monday, while yields on Italian and Spanish bonds rose sharply on fears of a Greek default, compounded by the failure of EU finance ministers to agree new steps to resolve Europe's debt crisis at weekend talks.
International lenders told Greece on Monday it must shrink its public sector and improve tax collection to avoid running out of money within weeks as investors spooked by political setbacks in Europe dumped risky euro zone assets.
Finance Minister Evangelos Venizelos held what Greece termed "productive and substantive" talks by telephone with senior officials of the European Union and International Monetary Fund after promising as much austerity as necessary to win a vital next instalment of aid.
Before the talks, which will resume on Tuesday evening after meetings of experts through the day, the IMF representative in Greece spelled out steps Athens must take to secure the 8 billion euro loan payment it needs to pay salaries and pensions next month. (Reporting by Wayne Cole in Sydney; Editing by Balazs Koranyi and Ed Davies)