By Abhinav Ramnarayan and Dhara Ranasinghe
LONDON (Reuters) - Italy's 10-year bond yield soared to a 4-1/2 year high on Tuesday after an Italian lawmaker said that most of the country's problems would be solved by ditching the euro, deepening market concerns over its public finances.
The comments by Claudio Borghi, economic head of the League party, pushed the spread (IT10YT=RR) (DE10YT=RR) between Italian and German yields to the widest in more than five years, briefly hitting 302 basis points and as euro zone officials warned of a return to crisis days, the Italian/Spanish yield gap was at its widest over any closing price in the last 20 years.
The reference to the possibility of Italy leaving the euro jolted a market already shaken by a budget proposal last week that put Rome on a collision course with Brussels.
Borghi on Tuesday clarified that the government had no intention of leaving the euro and Prime Minister Giuseppe Conte said Italy is totally committed to the currency.
This bought some calm to bond markets, with Italian yields pulling away from their highs, but borrowing costs remained elevated as concerns about the fallout from Italy's 2019 budget plans lingered.
Deputy Prime Minister Luigi Di Maio reiterated Italy would not change its budget deficit targets.
"Fundamentally, investors know Italy's government is not going to turn on its commitments, so you are still going to have a fiscal policy that is inappropriate, given Italy's debt metrics," said Chris Scicluna, head of economic research at Daiwa Capital Markets.
Italy's 10-year government bond yield (IT10YT=RR) hit a 4-1/2 year high of 3.44 percent, before pulling back to 3.36 percent -- still up 7 basis points on the day.
Italy's two-year bond yield was up 5 bps at 1.42 percent and five-year yields briefly jumped 21 bps to 2.77 percent, both hitting their highest in about four months. (IT2YT=RR) (IT5YT=RR)
Trading volume in two-year BTP futures in the last two days is the heaviest since May
"In this environment when everyone is nervous, these comments just add to the risk-off sentiment," said Commerzbank (DE:CBKG) strategist Christoph Rieger. "It smells clearly like the crisis days," he added, referring to the euro zone debt crisis of 2010-2012, when the breakup of the bloc was a possibility.
Rieger said market sentiment was also hit by comments from the European Commission head Jean-Claude Juncker comparing Italy with Greece.
ITALIAN BANKS, EURO HIT
The euro fell to a six-week low at $1.1505 (EUR=) after Borghi's comment and shares in Italian banks (FTIT8300), whose government bond holdings make them sensitive to political developments, fell as much as 3.9 percent to their lowest in 19 months on fears a bond sell-off would cut their capital ratios, raise their funding costs and hamper efforts to cut bad loans.
The bank index was down 0.8 percent, with shares in Italy's largest lenders Intesa Sanpaolo (MI:ISP) and UniCredit (MI:CRDI) both falling more than 2.5 to multi-month lows.
The cost of insuring exposure to Italian sovereign debt and the debt of the country's largest lenders also rose sharply.
The Italian government is to finalize the 2019-2021 budget program later on Tuesday, Di Maio said.
"Neither the EU or Italy is incentivized to compromise it seems, at least in the opening gambit of the talks," said Patrick O'Donnell, investment manager at Aberdeen Asset Management.
He said Italy's 10-year borrowing costs could reach 4 percent by the end of the year.
Outside Italy, euro zone bond yields fell as investors retreated to the safety of better-rated borrowers such as Germany, Netherlands and Austria.
Germany's 10-year bond yield slipped three bps to 0.44 percent (DE10YT=RR), while Spanish and Portuguese bond yields (ES10YT=RR) (PT10YT=RR) were little changed - showing no signs of contagion from the Italy bond sell off.