LONDON, May 28 (Reuters) - Italy's bond yields rose sharply for a second day on Tuesday as its deputy prime minister hit back over what he said were European Union plans to slap a fine on the country for spending too much.
Matteo Salvini said the EU could impose a 3 billion euro fine on Italy due to its rising debt and structural deficit and added he would use "all his energies" to combat that threat.
European Economic Commissioner Pierre Moscovici is not in favour of using financial sanctions against Italy as a tool to enforce EU budget rules, but the option exists if needed, a senior member of his cabinet said on Tuesday.
Italian government bond yields rose 7-10 basis points across the board, with the 10-year yield hitting a one-week high of 2.726%, having already risen around 11 bps on Monday and marking the sharpest two-day rise in benchmark borrowing costs since the start of the year.
"There is a fear that this conflict (between Rome and Brussels) could heat up again. Certainly everyone expected it to heat up in the autumn, but nerves are rising already," said DZ Bank strategist Daniel Lenz, referring to potential tensions when Italy formulates its 2020 budget.
"Comments by the Italian government saying over and over again they want to renegotiate EU fiscal rules is really putting BTPs (Italian bonds) under pressure."
The tensions are affecting risk sentiment through the market, with the single currency dipping slightly to $1.1185 while German 10-year Bund yields dropped to its lowest in nearly two years at -0.163%.
Other high-grade euro zone bond yields were also lower across the board in a risk-off environment,
"It is a continuation of a trend that we've seen in risk sentiment, which is driven more by the tone of trade talks between U.S. and China rather than the political headlines," said Mizuho rates strategist Antoine Bouvet.
The ouster of Austrian Chancellor Sebastian Kurz added to the nerves, however, and Spanish and Portuguese bond yields plumbed record lows on the back of strong showings from Socialist governments in both countries in the EU parliamentary elections.
Spain's 10-year government bond yield briefly dropped below 0.80% for the first time ever before settling at 0.807%, down 2 bps on the day, while Portugal's 10-year bond yield was down 3 bps at 0.94%.
Greek benchmark government bond yields dipped as much as four basis points at one stage to 3.12 percent, with the prospect of a national cheering a market hoping for a more rightist government.
"This strong spread-tightening is because of this news about snap elections by the end of June by the earliest, but early summer in any case," said Lenz of DZ Bank. "That would most likely put an end to (left-wing) Syriza and a centre right government would take over."