UPDATE 2-Moody's outlook decision triggers biggest one-day Italy bond rally since June

Moody's kept the outlook at stable, triggering a relief rally across Italian bond and stock markets.

Italian sovereign bond yields headed on Monday for their biggest daily drop since June after Moody's agency held off cutting the country's credit rating outlook to negative and the government promised not to expand the deficit further.

Moody's downgraded Italy's rating to Baa3 - the lowest investment grade category - on Friday as expected. But investors had fretted it would also set the outlook at "negative" following high-spending budget proposals that put Rome at odds with Brussels.

Moody's kept the outlook at stable, triggering a relief rally across Italian bond and stock markets.

That decision pushed the threat of a ratings cut to junk further into the future. Fears of such a cut had recently sent bond yields to 4-1/2-year highs.

"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.

Italy's two-year government bond yield dropped 25 basis points to a two-week low of 1.42 per cent. The benchmark 10-year yield was 14 bps lower at 3.44 per cent at 1045 GMT.

The Italy/Germany 10-year government bond yield spread tightened below the 300 basis point mark at the same time.

However, jitters remain as the European Union is expected to ask Italy on Tuesday to revise its draft budget in what would be the first such action against a member state.

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

Analyst expectations are mixed, with some expecting a one-notch downgrade while others expect only a change in the outlook to negative from stable currently.

The session was volatile as a result; yields rose off early lows, before receiving fresh impetus to move down around 10.15 GMT when the Italian Treasury told the European Commission it would stick to its contested budget plans, but promised not to further expand the deficit in the 2020-2021 period.

Should the EU decide to reject the draft budget anyway, it would formally begin a long legal dispute that will increase market pressure on Italy until it is resolved.

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

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 bps to 0.475 per cent.