By Virginia Furness
LONDON (Reuters) - Italian bonds rallied on Wednesday, pushing two-year yields down as much as 23 basis points as markets shrugged off the European Commission's rejection of Rome's draft budget and focused on the possibility of compromise between the two sides.
Deputy Prime Minister Matteo Salvini refuted a La Stampa newspaper report that he was open to reviewing the 2019 deficit of 2.4 percent of GDP, but said other aspects of the budget could be discussed.
Prime Minister Giuseppe Conte said he was worried about Italy's bond spread over Germany and that the government would respond with reforms.
The Italy/Germany 10-year bond yield spread tightened to 313 basis points, having widened to 335 bps on Tuesday (DE10IT10=RR). It has more than doubled this year.
"There is obviously a hint in the reports from Italy that there might be some tweaks to the budget in due course," said Chris Scicluna, head of economic research at Daiwa Capital Markets in London.
"I don't think there will be substantive changes but we did have a significant selloff yesterday, so there's a better mood around bond markets today."
The European Commission said the Italian budget does not comply with the EU debt reduction criteria and that an excessive deficit procedure is warranted.
While the euro (EUR=) briefly turned negative and Italy's benchmark stock index (FTMIB) hit a session low on the news, markets soon recovered. Italian bank shares were up 2.5 percent on the day (FTIT8300) and bond yields extended their slide.
"We know how negotiations work in Europe and the most likely outcome in this case is that both sides agree on a compromise," said Jonas David, a strategist at UBS Global Wealth Management. "We may see further negative headlines but at this stage we need to read between the headlines a bit."
Italy's two-year bond yield fell 23 bps to touch 1.15 percent, the lowest in almost two weeks, while 10-year yields were down 13 bps, falling to about 3.49 percent (IT10YT=RR).
Yields were set for their biggest daily drop in over three weeks, with an improvement in global risk sentiment helping equity markets to stabilize.
Italy's bond price gains also followed hefty losses on Tuesday, caused partly by a "BTP Italia" retail debt sale in which small investors took up just 723 million euros ($824 million) of the bonds on Monday and Tuesday. The previous such sale had received orders worth 3.7 billion euros in the first two days.
SKEPTICAL
Many remain skeptical about a sustained Italian recovery, noting Rome had made no significant changes in the revised budget it submitted to Brussels.
"We don't think they're going to budge much. There might be some word play with the Commission, but Italy is still going to run a deficit of 2.4 percent," said Lyn Graham Taylor, rates strategist at Rabobank.
Meanwhile, PIMCO's chief investment officer for global fixed income, Andrew Balls, said the possibility of Italy defaulting on its debt is unlikely but cannot be ruled out altogether.
As Italian yields fell, Greece's bond market also recovered slightly from a heavy selloff in the previous session, with five-year yields down 3 bps (GR5YT=RR).
They had earlier touched the highest in more than two months, coming under pressure from renewed concern about the Greek banking sector and contagion from Italy's volatility.
The Commission said on Wednesday Athens needed to speed up implementation of reforms.
The rally in riskier euro zone bonds dented demand for safer debt, with 10-year German yields rising 2 basis points to 0.37 percent (DE10YT=RR).
Graphic: Italian bond yields fall - https://tmsnrt.rs/2R2kqHR