UPDATE 2-Italian bond market on edge ahead of ratings verdict

Italy's short-dated bond yields hit their highest levels in almost three months on Friday, as remarks from an official that an EU budget ceiling could be exceeded if needed fuelled bearish sentiment towards debt markets ahead of a key rating review.

Italy could exceed the European Union's 3 percent deficit ceiling next year if the extra spending is needed to make sure the country's infrastructure is safe, a senior government official said.

A coalition of the far-right League and anti-establishment 5-Star Movement plans to increase spending and cut taxes, raising concern about Italy's debt sustainability and a potential clash with European Union rules on fiscal discipline.

"These comments provide yet another reminder that investors should be watching Italy and should be worried," said Chris Scicluna, head of economic research at Daiwa Capital Markets.

5-Star is pushing for a budget deficit next year that is triple the previous government's goal and near double, the level Economy Minister Giovanni Tria is prepared to accept, Italian newspapers said on Friday.

Italy's two-year bond yield rose to 1.44 percent, its highest in almost three months and was last up 5 basis points on the day. Five-year Italian bond yields also rose to almost three-month highs, climbing to 2.56 percent.

Concerns about a spending binge in Italy, the euro zone's third biggest economy and one of its most indebted, have put the spotlight on the country's ratings outlook.

Fitch Ratings is due to release its latest review after the market close. It rates Italy's BBB, with a stable outlook.

Analysts say a Fitch downgrade is unlikely as the government has yet to detail its spending plans. They did not rule out a cut in the outlook to negative, however.

Last week, rival agency Moody's said it was extending its review for a possible downgrade of Italian debt to gain "better visibility" on the fiscal path and reform agenda.

"There are several analysts saying that the market is priced for a ratings downgrade ahead," said Patrick O'Donnell, an investment manager at Aberdeen Asset Management.

"Our view is that the market is underpriced for the opening gambit of the budget talks. It looks like to us that you are going to get a pretty significant fiscal deficit and that may be negotiated back."

Italy's 10-year bond yield was steady at 3.20 percent, having reversed early falls. It was set to end August up more than 45 bps.

The gap over benchmark German Bund yields was at 286 bps, having reached around 288 bps on Thursday -- the widest since July 2013.

"In our view, there is excessive bearishness around Italy and Italian spreads are pricing in too much euro break-up risk," said Mark Dowding, a senior portfolio manager at BlueBay Asset Management. He said he had been adding to an overweight position in Italian bonds in the past week.

Other euro zone bond yields were marginally lower and showed little reaction to data showing inflation in the bloc eased to 2 percent in August from 2.1 percent in July.

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