* EU rejects Italy draft budget, gives Rome 3 weeks
* Italian yields up 7-8 bps across the board
* Italy/Germany spread widens to 315 bps
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Adds background, quotes)
By Abhinav Ramnarayan
LONDON, Oct 23 (Reuters) - Italian bond yields rose sharply on Tuesday, reversing falls earlier in the session, as the European Commission rejected Italy’s draft budget and gave Rome three weeks to come up with a revised version.
The Commission sent back the 2019 budget for breaking European Union rules, exercising for the first time a power it obtained during the sovereign debt crisis.
“The Italian government has three weeks to rewrite its budget proposal which seems quite unlikely to me; if anything, (Italy’s) tone has been quite belligerent,” said DZ Bank rates strategist Christian Lenk. “The car is moving further towards the wall without anyone hitting the brakes.”
Italy’s two-year borrowing costs rose 12 basis points to hit the day’s high of 1.58 percent, reversing earlier falls, before easing back a touch to around 1.53 percent by 1500 GMT. Benchmark 10-year yields rose to 3.586 percent before dropping slightly to 3.55 percent, still up eight bps on the day.
The closely-watched Italy/Germany 10-year bond yield spread widened to 315 bps, 12 bps wider on the day.
Investors headed instead for the safety of better-rated euro zone government debt, pushing lower the borrowing costs of countries such as Germany and France.
Germany’s 10-year government bond yield was down four bps at 0.41 percent, pushed down also by a global stock market selloff .
Meanwhile, Italy’s top share index was down 1.1 percent, staying above session lows hit in early trading, while the banking index was down 0.7 percent, on course for its lowest close since December 2016.
Italy’s contentious spending plans had pushed yields to 4-1/2 year highs last week on concern they would lead to conflict with Brussels and hurt Italy’s credit ratings.
On Monday, the Italian Treasury told the Commission that it would stick to its contested budget plans, but promised to intervene if it failed to meet its debt and deficit goals.
But Commission Vice President for the euro, Valdis Dombrovskis, told a news conference this clarification was not convincing enough to change the EU’s conclusions.
The rise in yields comes towards the end of what has been a volatile couple of sessions for the Italian bond market.
On Monday, Italian debt rallied strongly after Moody’s set a stable outlook on the country’s credit rating, though it delivered an expected downgrade to Baa3, the lowest investment grade rating
A report by Il Messaggero earlier on Tuesday suggested the coalition government was ready to adjust its 2019 budget plans should markets react negatively.
While that boosted bonds for a while, those gains have been all but wiped out. At 3.56 percent, Italian 10-year yields are just three basis points below Friday’s closing level, which was touched before the Moody’s decision. (Reporting by Abhinav Ramnarayan; editing by Sujata Rao and David Stamp)