October 23, 2018 / 12:40 PM / 25 days ago

UPDATE 2-Italian bonds steady after report coalition ready to adjust budget

* Short-dated Italian yields edge lower as market steadies

* Spanish, French debt also benefits from improved tone

* EU due to discuss and decide on response to Italian budget

* Focus now on Standard & Poor’s ratings review

* Safe haven bonds down 2-3 bps (Recasts to reflect change in yields, adds quotes and background)

By Virginia Furness and Abhinav Ramnarayan

LONDON, Oct 23 (Reuters) - Italian government bonds steadied on Tuesday after a newspaper report suggested the coalition government was ready to adjust its 2019 budget plans should markets react negatively, boosting other euro zone debt markets as well.

The report in Il Messaggero helped to support a market that has been battered by Rome’s contentious spending plans in recent weeks.

Also, Mario Centeno, who heads the Eurogroup of euro zone finance ministers, said late on Monday that the latest messages from Rome and the European Commission over the Italian budget are “very positive” and he expects agreement to be reached on the blueprint.

“The feeling among investors is that the tone of Italian political leaders has been slightly less defiant this week than previously, and more aimed at trying to find some sort of compromise,” said ING strategist Martin van Vliet.

“I personally was quite struck by a comment by Centeno that they were trying to find a compromise and were upbeat on the prospects,” he added.

Having risen sharply in early trade, short-dated Italian government bond yields were two basis points lower on the day.

Longer-dated yields were unchanged on the day and the closely-watched Italy/Germany 10-year bond yield spread was at 305 bps, well below the recent highs of over 330 bps.

Just the lack of further negative news on Italy encouraged investors to buy up some other euro zone government debt, said Van Vliet. Spanish 10-year yields were down five bps and Portuguese, French and Belgian yields were also lower on the day.

Analysts warned however, that risks lie ahead. Most notably, the Commission will decide on Tuesday the next steps in the procedure for assessing Italy’s 2019 draft budget.

Also, Lyn Graham Taylor, rates strategist at Rabobank, described the Il Messagero report as “pie in the sky” given the coalition government’s stance.

“The content of the report is that they would be prepared to water down some of their proposals if the market puts them under too much pressure. We are in a funny feedback loop - if the spread stays where it is they won’t have to do this, but it probably won’t stay here, something has got to give,” he said, referring to the yield gap between Italy and German bonds.

“We still favour being short Italy, on the basis that market pressure is the only thing that will drive a change in the budget.”

These Italian uncertainties, along with fears of a leadership challenge to British Prime Minister Theresa May over Brexit and global equity wobbles, kept German yields about two basis points lower, while other high-grade European debt was also well bid as investors sought safety, .

Italy’s bond market had enjoyed a rally on Monday after Moody’s lowered its credit rating to Baa3 - one notch above the much feared junk status - but with a stable outlook. Prime Minister Giuseppe Conte had also soothed fears of a euro zone crisis, saying: “Read my lips. There is no way Italy will leave the euro.” (Reporting by Virginia Furness; Editing by Sujata Rao, Andrew Heavens and David Stamp)

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