* Italy targets deficit falling to 2.2 pct of GDP in 2020
* Bond yields fall, euro rallies on report
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds new landmark on Italian yields)
By Dhara Ranasinghe
LONDON, Oct 3 (Reuters) - Italian government bond yields fell sharply on Wednesday on reports that Rome plans to cut the budget deficit faster than it had previously indicated, easing fears about the fiscal policy of the euro zone’s third-biggest economy.
Rome foresees the budget deficit falling to 2.2 percent of gross domestic product in 2020 and to 2 percent in 2021 from the 2.4 percent expected next year, a government source from the right-wing League said on Wednesday.
That bought relief to the bond market, the euro and stocks.
Later in the session, Economy Minister Giovanni Tria appeared to confirm the report, saying Italy’s budget deficit will fall gradually from 2020.
Debt markets, in particular, have taken a beating since the coalition government - of which the League is a member - said last week it planned to run a deficit of 2.4 percent of GDP over the next three years, tripling the previous target.
Italian borrowing costs were lower on Wednesday after four days of sharp rises, and short-dated yields even recorded their biggest daily fall since early June, down 22-23 basis points.
The Italian government’s multi-year budget plan will not be published on Wednesday, government sources said, as ministers continue to discuss the economic and fiscal targets.
The 10-year Italian government bond yield was down 12 bps at 3.31 percent, well below Tuesday’s 4 1/2-year high around 3.46 percent.
That left the gap over benchmark German bond yields , a closely-followed indicator of relative country risks, at 283 bps versus 300 bps late Tuesday.
“The deficit forecast news is main reason markets are doing what they are doing today,” said KBC rates strategist Mathias van der Jeugt.
“But this is too little to bridge the gap between the EU and Italy. We might get some more relief, but I think it will be short-lived unless Italy comes up with a better proposal that is more aligned with what the EU wants.”
EU Commission President Jean-Claude Juncker drew parallels on Monday between Italy’s budget plans and the finances of Greece, which only emerged from its third international bailout in August.
“Let’s not forget the yield is pretty high, so there is a carry element as well, so people latch on to any news flow that may be coming through,” said Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers, referring to the recovery in Italian bonds.
UBS Wealth said that it now saw two-year Italian bonds as attractive after the heavy selloff.
The euro and stocks also benefited from the more positive noises coming from Rome. Italian shares rose 1.2 percent, outperforming European stocks overall .
As Italy’s bond market rebounded, yields on higher-rated euro zone bonds rose. Germany’s 10-year Bund yield was up 6 bps at 0.48 percent by the close.
Reporting by Dhara Ranasinghe, additional reporting by Sujata Rao; editing by Larry King and Alexander Smith