* Projected budget deficit of 2.4 pct worries market
* Italian bond yields rise 35-42 bps across the curve
* Italy/Germany 10-year spread widest in three weeks
* Core inflation surprise pushes German yields even lower (Updates pricing)
By Abhinav Ramnarayan
LONDON, Sept 28 (Reuters) - Italy’s government bonds yields surged on Friday to their highest since the end of May and stock markets fell after government officials agreed a budget that will see the country run a bigger-than-anticipated deficit for the next three years.
Italy’s government has targeted the budget deficit at 2.4 percent of gross domestic product for 2019 and beyond, defying Brussels and marking a victory for party chiefs over Economy Minister Giovanni Tria, who had pledged to limit the gap to 2 percent.
Deputy Prime Ministers Luigi Di Maio and Matteo Salvini, heads of coalition partner parties, said in a statement there was accord within the government for 2.4 percent and described it as “a budget for change”.
The announcement, which came after coalition officials spent weeks soothing earlier fears of a spendthrift budget, fuelled a surge in bond yields, which had gradually eased over the summer months. But Friday’s selloff set up the market for their worst day since the brutal May 29 selloff, up 22-41 basis points across the curve.
The news which renews the prospect of a spat between Italy and the European Commission also weighed on the euro, which traded below $1.16 for the first time in 2-1/2 weeks.
“Markets have passed their judgement already and it’s pretty clear they don’t like it,” said Stewart Robertson, Senior Economist at Aviva Investors.
He said that while the government has tried to avoid an outright confrontation with the European Union by keeping the deficit below the 3 percent-mark, the bigger deficit could still cause discord.
EU Economic Commissioner Pierre Moscovici has said only that there was “nothing to be gained from a showdown”. Dutch Prime Minister Mark Rutte said the budget plan was “worrying”.
Robertson said the issue was that Rome had been committed to a gradual reduction in its fiscal deficit which did not seem to be the case any more.
“It not just that they went for a deficit number of 2.4 percent but the fact it stays there for the next three years,” he added.
The renewed political risks pushed Italy’s five-year credit default swaps almost 30 bps higher, according to IHS Markit data, and analysts also highlighted Italy’s sovereign credit rating as a particular concern. Italy is rated two notches above the dividing line between investment grade and junk.
Italy’s two-year bond yields — most sensitive to political noise — were last up 31 basis points at 1.10 percent, having touched a high of 1.25 percent. Five-year yields rose 37 bps at 2.28 percent and 10-year yields up 27 bps at 3.18 percent.
The bonds were set for their worst day since May 29, and BTP futures too were set for their biggest one-day fall since May 29.
The closely-watched Italy/Germany 10-year bond yield spread was at its widest in three-weeks at 279 basis points, before receding slightly to 268 basis points. This reflects the premium investors demand to hold Italian risk over “safe” German debt.
“We see potential for the 10-year (Italy-Germany) spread to reach 300 basis points over the coming two weeks,” said Mizuho’s head of rates Peter Chatwell, adding the European Commission’s reaction would now be crucial.
Italian stocks meanwhile fell nearly four percent, their biggest one-day fall since June 2016, with Italian banks, with their big holdings of sovereign bonds, leading the selloff.
The banking index was down over seven percent, also set for its biggest one-day loss since June 2016 with shares in the country’s two largest banks, Intesa Sanpaolo and UniCredit also falling by six percent.
The shares, however, remained above the lows hit in August when there were concerns the deficit target could shoot up to 3 percent.
The spike in risk pushed down yields on higher-grade euro zone government bonds, with Germany’s 10-year bond yield, the benchmark for the region, down six bps at 0.467 percent.
German yields came under further downward pressure as euro zone inflation rose in September but measures of underlying price pressures dipped unexpectedly, likely fuelling concern at ECB as it prepares to curb stimulus.
Reporting by Abhinav Ramnarayan Editing by Sujata Rao and Matthew Mpoke Bigg