(Corrects para 2 to show yields were up, not down, at open)
* EU due to discuss and decide on response to Italy budget
* Focus now on Standard & Poor’s ratings review
* Italian yields up to 10 bps higher
* Safe haven bonds down 2-3 bps
By Virginia Furness
LONDON, Oct 23 (Reuters) - Italian government bonds reversed some early losses on Tuesday, with short-dated yields as much as six basis points lower after Il Messagero newspaper reported the coalition government was prepared to adjust budget plans should markets demand it.
The markets had opened sharply lower, with two-year yields up 10 bps at one point, as markets awaited the European Union’s official response to Rome’s 2019 budget proposal and an upcoming ratings review by Standard & Poor’s.
However, the report by Il Messagero swung sentiment around. The newspaper did not say whether the alternative budget would lower the deficit to less than 2.4 percent but noted that a euro exit was not on the cards.
However, the report comes just a day after Italy told the European Commission it would stick to its contested 2019 budget plans in defiance of European Union fiscal rules, though it promised not to inflate its deficit any further in the years ahead.
The Commission will decide on Tuesday the next steps in the procedure for assessing Italy’s 2019 draft budget.
Lyn Graham Taylor, rates strategist at Rabobank, said the Il Messagero report had moved the market but described it as “pie in the sky” given the coalition government’s stance.
“The content of the report is that they would be prepared to water down some of their proposals if the market puts them under too much pressure. We are in a funny feedback loop - if the spread stays where it is they won’t have to do this, but it probably won’t stay here, something has got to give,” Graham-Taylor said, referring to the yield gap between Italy and German bonds.
The gap, effectively a gauge of Italian risk, narrowed around 10 bps to 303 bps after the Il Messagero report . It had recently hit 5-1/2 year highs approaching 340 bps, levels that could be problematic for the country’s economy and borrowing costs.
“We still favour being short Italy, on the basis that market pressure is the only thing that will drive a change in the budget,” Graham-Taylor added.
By 0830 GMT, two-year Italian yields were down 3 bps to 1.43 percent, five-year yields likewise slipped 3 bps to 2.76 percent and 10-year yields were down 2 bps at 3.45 percent.
However, Italian uncertainties, along with fears of a challenge to British Prime Minister Theresa May and global equity wobbles, kept German bond yields lower, while other high-grade European debt was also well bid as investors sought safety,.
However, German bond prices too trimmed gains, with yields standing some 2 bps lower at 0.43 percent
Italy’s bond market had enjoyed a rally on Monday after Moody’s lowered its credit rating to Baa3 - one notch above the much feared junk status - but with a stable outlook. Prime Minister Giuseppe Conte had also soothed fears of a euro zone crisis, saying: “Read my lips. There is no way Italy will leave the euro.”
But attention will now focus to a ratings review by Standard & Poor’s on Friday, as well as the budget response later today.
“Not all the information is on the table yet, the base case is that S&P will lower the outlook but there is also a risk of a downgrade there, so many market participants are reluctant to take positions in BTPs,” said ING rates strategist Benjamin Schroeder. (Reporting by Virginia Furness; Editing by Sujata Rao and Andrew Heavens)