By Virginia Furness
LONDON (Reuters) - Italian bond yields fell on Wednesday after the country's economy minister, Giovanni Tria, said the government will do all it can to recover market confidence.
Tria moved to reassure markets after a volatile early trading session, saying that the current Italy/Germany spread did not reflect Italy's economic fundamentals from the point of view of debt sustainability.
The two-year Italian government bond yield fell sharply after his comments, and was down eight basis points on the day to 1.64 percent, reversing earlier rises.
Italy's 10-year yield was down three basis points at 3.50 percent, while the key spread over Germany tightened to 295 basis points.
Yields had moved higher earlier in the session after a senior Moody's Analytics economist told La Stampa newspaper that Italy's budget is "a mistake," adding to comments from a senior League lawmaker that a downgrade of the Italian debt by credit rating agencies is possible.
Moody's and S&P Global, which both rate Italy two notches above junk, are due to provide an updated opinion on Italy's credit rating in the second half of October. Analysts say around one downgrade is already priced in.
"The outlook after the downgrade is now the focus," said DZ Bank strategist Rene Albrecht. "It will be a volatile session again but we think the government is now more spread-sensitive."
The closely-watched Italy/Germany 10-year bond yield spread was tighter by four basis points on the day at around 295 bps after Tria's comments. (IT10YT=RR) (DE10YT=RR)
Analysts say the recovery in bond yields is partly a result of an expectation that the government will row back on some of its budgetary promises, despite comments from senior politicians to the contrary.
"There is hope in the market that the government makes some concession on the headline deficit target to the commission," said Antoine Bouvet, rates strategist at Mizuho.
"There is a well-defined pattern of governments buckling under market pressure because if yields rise to higher levels then the debt becomes less sustainable."
On Tuesday, Italy's parliamentary budget office refused to validate the multi-year budget plan, saying the forecasts for economic growth were too excessive.
But Italy remains committed to its budget forecast, Tria said, following comments from the leaders of the ruling populist coalition, Luigi di Maio and Matteo Salvini, who reiterated that the budget would not be amended.
Analysts say that should the spread of Italy's 10-year bond yield over Germany remain above a 300 basis point "threshold", the government would likely move to soothe markets.
European banking supervisors have stepped up their monitoring of liquidity levels at Italian banks after the sharp increase in bond yields, though there was no cause for alarm, a senior EU source said on Tuesday.
Elsewhere euro zone bond yields were up to one basis point higher, with Germany's 10-year yield, the benchmark for the region, at 0.55 percent (DE10YT=RR), (FR10YT=RR).