* 10-year BTP yield hits 4 1/2-year high, 2-yr yield up 25 bps
* Italian stocks lowest since April 2017, banks tumble
* EU raises worries over Italian budget; Rome defiant
* ECB’s Knot: Timing of ECB rate hike not fixed (Updates prices)
By Dhara Ranasinghe and Danilo Masoni
LONDON/MILAN, Oct 8 (Reuters) - Italy’s borrowing costs soared on Monday, bank stocks tumbled and the euro weakened as a war of words between Rome and the European Union over Italian budget plans escalated.
As Italian bond yields jumped by as much as 30 basis points, the Italian/German 10-year bond yield gap - a closely watched measure of country risks - blew out to more than 300 bps.
That rippled across markets: Italy’s stock market hit its lowest since April 2017, bank shares tumbled 4 percent and the euro weakened.
Italian Deputy Prime Minister Matteo Salvini, speaking at a news conference with French far-right leader Marine Le Pen, on Monday denounced European Commission President Jean-Claude Juncker and Economics Commissioner Pierre Moscovici as enemies of Europe.
The Commission has told Italy it is concerned over its budget deficit plans for the next three years since they breach what the EU asked the country to do in July.
Salvini also said on Monday that Italy would not cave in to market pressure and backtrack on its plans to increase deficit spending next year.
“The war of words is reinforcing a belief that we are going to get a clash between Italy and the European Union over the budget,” said Martin van Vliet, senior rates strategist at ING.
“Salvini is making crystal clear that they have no plans to go back to the drawing table.”
Rome is to submit its draft budget to the Commission, which will check whether it is in line with EU rules, by Oct. 15. .
Italy’s 10-year bond yield rose to its highest level since early 2014 at 3.63 percent, before closing at 3.59 percent; two-year yields soared 30 bps to a four-month high at 1.656 percent before settling at 1.57 percent.
Analysts noted a sharp selloff in short-dated Italian bills as another sign of market unease. The yield on a nine-month Italian Treasury bill was up 25 bps at 0.87 percent at one stage.
The Italian/Spanish yield gap was its widest in over 20 years at 203 bps, while the price on five-year Italian credit default swaps rose 10 bps on the day to 274 bps.
Italian market turmoil boosted higher-rated bonds, which have been under pressure in the last week from strong U.S. data and expectations for higher U.S. interest rates.
Even hawkish comments from Dutch central banker Klaas Knot failed to dent the rally in so-called “core” bond markets.
The European Central Bank will have to start discussing the timing of an interest rate hike in January, Knot said.
German 10-year bond yields fell 3 bps to 0.53 percent , down from 4-1/2 month highs hit last week.
“We are a bit surprised by the strength of the reaction in bond markets, but it appears the market is jumping to the conclusion that the European Commission will take a hard-line stance when Italy submits its budget,” said Mizuho rates strategist Antoine Bouvet.
Europe’s single currency fell almost 0.5 percent against the dollar. It tumbled 0.5 percent versus the Swiss franc , its biggest daily drop in a month.
The bond rout dealt Italian banks a fresh blow.
Domestic government bonds account for 10 percent of Italian banks’ total assets, making them vulnerable to a rise in Rome’s debt costs.
Shares in Intesa Sanpaolo, one of Italy’s strongest banks, tumbled 3.3 percent. UniCredit fell 3.6 percent, dragging the Italian stock market down 2.4 percent on a day when broader European stocks fell 1.1 percent.
The Italian stock index is now trading at a wider valuation discount to euro area equities than during the euro debt crisis, suggesting that Rome’s budget woes are penalising Italian companies particularly hard. Cheap valuations however could eventually lure back investors hunting for bargains.
Italy’s expansionary multi-year budget plan published late on Thursday may backfire on the populist government, say analysts, who see a risk of rising borrowing costs and ratings downgrades.
Salvini said he hoped ratings agencies would show no prejudice towards Italy. He again ruled out an exit from the euro.
“The euro zone without Italy is not something I could see,” said Talib Sheikh, manager of the Jupiter Flexible Income Fund.
Moody’s, which has a negative outlook on Italy’s Baa2 rating, has said it would give its verdict by the end of October. S&P is scheduled to review its Italy rating on Oct. 26.
Reporting by Dhara Ranasinghe and Danilo Masoni; Additional reporting by Virginia Furness, Abhinav Ramnarayan and Saikat Chatterjee; Editing by Mark Heinrich and Richard Balmforth