Italian borrowing costs jump and stocks fall after "budget for change" (UPDATE 2-)

Italy's government bonds and stock market were hit hard on Friday after government officials agreed on a budget that will see the country run a bigger-than-anticipated deficit for the next three years.

Italy's government has targeted the budget deficit at 2.4 percent of gross domestic product for 2019 and beyond, defying Brussels and marking a victory for party chiefs over Economy Minister Giovanni Tria, who had pledged to limit the gap to 2 percent.

Deputy Prime Ministers Luigi Di Maio and Matteo Salvini, heads of coalition partner parties, said in a statement there was accord within the government for 2.4 percent and described it as "a budget for change".

The announcement, which came after coalition officials spent weeks soothing earlier fears of a spendthrift budget, fuelled a surge in bond yields, which had slipped over the summer from their late-May highs.

Italian government bonds were set for their worst day since a brutal May 29 sell-off, up 34-42 basis points across the curve.

The news which renews the prospect of a spat between Italy and the European Commission also weighed on the euro, which traded below $1.16 for the first time in 2-1/2 weeks.

"Markets have passed their judgment already and it's pretty clear they don't like it," said Stewart Robertson, Senior Economist at Aviva Investors.

He said that while the government has tried to avoid an outright confrontation with the European Union by keeping the deficit below the 3 percent mark, the move could cause discord.

EU Economic Commissioner Pierre Moscovici has said only that there was "nothing to be gained from a showdown".

Robertson said the issue was that Rome had been committed to a gradual reduction in its fiscal deficit which did not seem to be the case anymore.

"It not just that they went for a deficit number of 2.4 percent but the fact it stays there for the next three years," he added.

The renewed political risks fuelled a 20 bps rise in Italy's five-year credit default swaps and analysts also highlighted Italy's sovereign credit rating as a particular concern. Italy is rated two notches above the dividing line between investment grade and junk.

Italy's two-year bond yields -- which have been most sensitive to political noise in recent months -- were up 41 basis points to 1.19 percent.

Five-year yields were up 43 bps at 2.33 percent and 10-year yields up 35 bps at 3.25 percent.

All three bonds were set for their worst day since May 29.

The closely-watched Italy/Germany 10-year bond yield spread was at its widest in three-weeks at 279 basis points. This reflects the premium investors demand to hold Italian risk over "safe" German debt.

"We see the potential for the 10-year (Italy-Germany) spread to reach 300 basis points over the coming two weeks," said Mizuho's head of rates Peter Chatwell, adding the European Commission's reaction would now be crucial.

Italian stocks meanwhile fell 3 percent, their biggest one-day fall since June 2016, with Italian banks, with their big holdings of sovereign bonds, leading the selloff. The fear is also that a credit rating downgrade for the sovereign would erode banks' capital buffers.

The banking index was down 6 percent, also set for its biggest one-day loss since June 2016 with shares in the country's two largest banks, Intesa Sanpaolo and UniCredit also falling by 6 percent.

The shares, however, remained above the lows hit in August when there were concerns the deficit target could shoot up to 3 percent.

The spike in risk saw yields on higher-grade eurozone government bonds fall, with Germany's 10-year government bond yield, the benchmark for the region, lower by 6 bps at 0.467 percent.

German yields came under further downward pressure as eurozone inflation rose in September but measures of underlying price pressures dipped unexpectedly, likely fuelling concern at ECB as it prepares to curb stimulus.