By Dhara Ranasinghe and Giulio Piovaccari
LONDON/MILAN (Reuters) - Italy's government bond yields rose on Friday and equities sold off after local media reported tensions within the ruling coalition government and a newspaper interview with a lawmaker raised fresh concerns about Rome's commitment to the euro.
The benchmark Italian stock index pared losses after Deputy Prime Minister Luigi Di Maio denied newspaper reports that he had demanded Economy Minister Giovanni Tria resign unless he backed government nominees to head key companies.
Still, signs of discord in the euro zone's third biggest economy served as reminder of heightened risks in Italy following the recent formation of a coalition government between the far-right League and anti-establishment 5-Star Movement.
Two-year government bond yields briefly jumped more than 10 basis points on the day, while an index of bank stocks tumbled to a three- week low.
According to a report in Italian daily Corriere della Sera, the head of the budget committee in Italy's lower house of parliament, Claudio Borghi, said the country would come out of the euro sooner or later.
Signs of tension between Tria and the government's two deputy prime ministers also weighed.
"BTPs (Italian bonds) are falling sharply, probably due to the Borghi comments, that he is sure the Italy will get out of euro soon or later, and due to tensions in the government on Tria," said one Milan-based trader.
One reason for strained relations is disagreement over appointments at some state-controlled firms including state lender Cassa Depositi e Prestiti (CDP), traders said. CDP is expected to be a crucial institution in the new Italian government's spending plans.
Several newspapers reported the deputy prime ministers have issued an ultimatum to Tria that he should back the government's nominees for key posts at the companies or resign.
La Stampa and Repubblica, in unsourced reports, said Luigi Di Maio and Matteo Salvini want Tria to back several nominations, which he has so far not done.
Di Maio's denial on Friday bought some brief relief, although both bond and stocks remained on the back foot.
Italy's two-year bond yield was last up 6 basis points at 0.61 percent (IT2YT=RR), having risen as high as 0.667 percent as markets digested the newspaper reports.
Italian 10-year bond yields were 4 bps higher, trading at 2.55 percent - pushing the gap over German Bund yields (DE10YT=RR) to 221 bps from around 218 bps late Thursday.
To view a graphic on Italian yields and spreads over German yields rise, click: https://reut.rs/2L8eJcG
"The fact that Tria is entering on a collision course with the two leaders of Italy's government forces has put (investors) on alert," said Marco Vailati, head of research and investments at Cassa Lombarda.
"A resignation would obviously be traumatic. The market reaction is logical, even though (the sell-off) could be seen as a buying opportunity should the whole thing turn out to be a journalistic exaggeration," he added.
The news did not seem to have a noticeable effect on the euro, which was up 0.1 percent on the day against the dollar (EUR=D3).
But as Italian bonds sold off, banking stocks in Milan underperformed the broader stock index.
Italy's banks index (FTIT8300) fell 1.3 percent to a three-week low, as rising yields hurt lenders who are big holders of Italian debt.
The broader Italian FTSE MIB equity index (FTMIB) fell 0.4 percent, underperforming the broader European market (STOXX), but moving off lows after Di Maio's comments.
"The reports out of Italy today are a reminder of just how dysfunctional the Italian government is," said Chris Scicluna, head of economic research at Daiwa Capital Markets in London. "It's not helpful that these parties are packed with euro sceptics."