UPDATE 1-Italy 10-yr yield drops by most since June as Moody's keeps outlook stable

Italian government bond yields dropped across the curve on Monday after rating agency Moody's kept the country's sovereign ratings outlook stable while delivering an expected downgrade on Friday.

Investors were worried the agency would not only downgrade Italy's sovereign rating to Baa3 - the lowest investment grade - but also set the outlook at "negative", increasing the risk of a junk rating for the euro zone's third-largest economy.

"Not only did Moody's keep the rating outlook as stable, but they were also fairly optimistic on the Italy deficit, saying it could be around 2.5 per cent for the next three years," said DZ Bank rates strategist Daniel Lenz.

"Other calculations, including ours, come to different (higher) conclusions, so overall it looks like a downgrade to junk is unlikely now from Moody's in the short term. We don't expect one from S&P, either," Lenz added.

S&P Global is scheduled to review Italy's credit rating on Friday. It now rates the country two notches above junk at BBB.

Italy's five-year government bond yield dropped 36 basis points to a two-week low of 2.63 per cent. The benchmark 10-year yield was 26.5 bps lower at 3.39 per cent, its biggest daily drop since early June.

The Italy/Germany 10-year government bond yield spread tightened to 284 bps.

The rally follows late-Friday gains that came after European Economic Affairs Commissioner Pierre Moscovici said he wanted to reduce tensions with Italy.

Italy's two-year government bond yield also extended falls by as much as 43 bps, reaching a two-week low of 1.24 per cent, after Italian Deputy Prime Minister Luigi Di Maio reiterated that the country does not intend to leave the euro.

Short-dated Italian debt has been particularly sensitive to any hint the country may reconsider its membership of the single currency bloc.

This came after an Italian government source told Reuters the European Commission was set to ask Italy to revise its draft budget on Tuesday, the first time ever it would take such action against a member state.

Di Maio said the Italian government was ready to discuss spending plans with the EU authorities.

"It does sound like there is a path to compromise," Lenz of DZ Bank said. "Investors are even speculating that Italy might consider reducing the budget deficit further."

Spanish and Portuguese government 10-year bond yields also dropped on Monday, by about 8 bps each.

That was partly because of the Italian bond rally but also because Moody's changed its rating outlook for the Spanish region of Catalonia to stable from negative. It said the economy had not been hurt by its unilateral declaration of independence last year.

Higher-grade euro zone bond yields rose as they lost some of their safe-haven bid, both in the light of the Italian news and as global stock markets rallied on hopes of stimulus from the Chinese central bank.

Germany's 10-year government bond yield, the benchmark for the region, was up 4.5 bps to 0.48 per cent.

(With inputs from agencies.)