* Italy/Germany yield spread hits 5-1/2 year high
* Italy’s five-year yield hits five-year high
* EU to send formal warning letter to Italy on budget (Adds background, quotes, updates prices)
By Virginia Furness
LONDON, Oct 18 (Reuters) - The gap between Italian and German 10-year bond yield spreads hit its widest level in 5-1/2 years after Brussels stepped up pressure on the government in Rome to rein in its budget ambitions.
EU authorities said they would send a formal warning letter over fiscal rule breaches in the 2019 draft - the first stage of a procedure that could lead to Brussels rejecting the budget and to fines against Italy.
Concerns over Rome’s expansive budget plans have weighed heavily on Italian government bonds in recent weeks, and on Thursday yields rose sharply across the curve, with the two-year bond yield up 22 bps in late trade at 1.855 percent.
Italy’s five-year yield rose 19 basis points to a five-year high at 3.15 percent, while its 10-year yield rose 13 bps to a one-week high of 3.663 percent.
The closely-watched Italy/Germany spread hit 324 basis points, the widest level since April 2013.
“I think the market is anticipating some tough debate between the EU and Italy, especially if they are starting this process that could lead to a budget rejection,” said Natixis rates strategist Cyril Regnat.
Italian Prime Minister Giuseppe Conte defended what he called Italy’s “beautiful” budget and said the EU letter was “not a cause for concern.”
Conte presented his budget to EU leaders in Brussels but it was not discussed in any detail, the head of the European Commission Jean-Claude Juncker said.
Amid the budget noise, Italy bought back 3.8 billion euros of government bonds maturing 2020, in conjunction with a new issue of five-year bonds.
Spain’s bonds also came under pressure with its 10-year yield rising eight basis points to a one-year high of 1.74 percent.
But the risky backdrop in Europe meant that 10-year German bond yields dropped to 0.402 percent, the lowest in two weeks.
Two-year U.S. Treasury bond yields rose to their highest since 2008, meanwhile, with minutes released on Wednesday showing the U.S. Federal Reserve is largely united on the need to raise borrowing costs further.
Reporting by Virginia Furness; Editing by Abhinav Ramnarayan and John Stonestreet