By Georgi Kantchev 

Investors continued to sell off Italian government bonds on Monday as the country's populist government clashed with the European Union over budget targets.

Yields on the country's 10-year bonds hit a 4 1/2 year high, rising 17 basis points to 3.593%. The two-year bond yield jumped to 1.557% near its highest level since June. Bond yields move inversely to prices.

Italian stocks sold off with the FTSE MIB shedding 2.3%. A potential ratings downgrade of the country's debt by major credit credit-rating firms also weighed on sentiment, analysts said. Banking stocks also suffered heavy losses, Banco BPM losing 5.8% and UBI Banca falling 4.9%.

The moves put pressure on the broader European market, with the euro falling by 0.4% against the dollar.

"Step by step, the pressure on Italy is ratcheting up," said Richard McGuire, head of rates strategy at Dutch lender Rabobank. "The danger is of this becoming a self-fulfilling prophecy."

Italian shares and government bonds have been selling off in recent days after the government significantly widened its budget-deficit target for next year to 2.4% of gross domestic product, creeping closer to the EU's 3% limit.

Late last week, the European Commission, the EU's executive arm, said Italy's budget plans are a "significant deviation" from the recommended fiscal policies and a "source of serious concern."

On Monday, Italy's interior minister, Matteo Salvini, criticized European Commission President Jean-Claude Juncker and Economics Commissioner Pierre Moscovici.

"The enemies of Europe are those sealed in the bunker of Brussels. It is Juncker and Moscovici who have brought fear and job insecurity to Europe, " Mr. Salvini told reporters.

Italy is the eurozone's biggest government borrower, but its government has promised policies that will likely add to the debt pile, such as tax reductions, a so-called citizens' income and pension overhaul.

The rise in Italian bond yields Monday widened the their gap over German bund yields to over 300 basis points. Other major European government debt markets were broadly stable.

Investors are awaiting possible downgrades by major ratings firms. S&P and Moody's are both expected to issue their reviews later this month, with the latter having already placed Italy on outlook for a downgrade.

A downgrade would push Italy's credit rating close to junk status, which if hit would make Italian debt off limits for some funds and put further pressure on the country's markets.

"As the possibility of Italy losing its investment grade has emerged on the horizon, institutional investors have naturally [reduced their holdings], as many of their funds cannot hold junk-rated debt, should that happen," Erik Nielsen, chief economist at UniCredit Bank, said in a note to clients.

A deepening selloff of Italian bonds and banks has revived concerns over the "doom loop" between weak lenders and fragile government finances. Italian banks have increased their already large portfolios of the country's bonds and the recent fall in their value will have eroded the sector's capital cushion, which is needed to protect it from future financial shocks.

Giovanni Legorano contributed to this article.

Write to Georgi Kantchev at georgi.kantchev@wsj.com

(END) Dow Jones Newswires

October 08, 2018 07:20 ET (11:20 GMT)