By Christopher Whittall, Alistair MacDonald and Marcus Walker 

Italy's credit was cut by Moody's Investors Service Friday to the lowest investment-grade rating, in a move that will likely add further selling pressure on Italian bonds and raise borrowing costs for the debt-laden country.

Italy's bonds had already sold off again on Friday before recovering later in the day. This past week, selling also spread to other Southern European economies, in a worrying sign for investors who until recently hoped that market jitters would be contained.

Moody's downgraded the country's credit rating to Baa3 from Baa2, citing a "material weakening in Italy's fiscal strength" after the government targeted higher budget deficits and stalled economic and fiscal reforms.

Italian bond yields have risen sharply since late September, when the country's government set a 2.4% budget-deficit target that put it at odds with the European Commission.

"Italy's public debt trend is vulnerable to weaker economic growth prospects, which would see the public debt ratio rise further from its already elevated level," Moody's said in an emailed statement.

While many investors had anticipated a credit downgrade, the move to one notch above a junk rating is still a significant threshold, given some funds can't hold sub-investment-grade bonds.

Further selling could add to pressure on the eurozone's markets.

The gap in yield between 10-year Spanish bonds and haven German debt hit its widest level since April 2017 during Friday's session before narrowing later in the day, according to Refinitiv, while Portuguese debt also came under pressure.

Investors hadn't sold the debt of other weaker Southern European economies. That kind of market contagion has rarely been seen since the depths of the eurozone sovereign-debt crisis over six years ago.

That changed this past week, as the extra yield premium investors demand to hold Spanish debt over similar German bonds climbed to 1.33 percentage points, according to Refinitiv, versus about one percentage point in late September.

Still, the selloff eased in European afternoon trading Friday -- with Italian bonds rallying after the country's 10-year yields hit their highest level since early 2014 earlier in the day. That turnaround came after a senior European Union official played down tensions with Italy's antiestablishment government.

But investors predicted the standoff between Brussels and Rome will continue, likely keeping markets volatile.

"People are very focused on [the] downside risk to Italy, and it has spilled over more in the last couple of sessions," said Ryan Myerberg, a portfolio manager at Janus Henderson Investors.

Mr. Myerberg said Spain's and Portugal's finances look solid. But in the short term, something of a "perfect storm" could cause their bonds to slide, including concerns over credit-rating firms downgrading Italy and crowded positioning in Spanish debt.

"They won't be immune if Italy continues to move higher in yields," he said.

Italy is the eurozone's third-largest economy and has a public debt load that equates to about 130% of gross domestic product. Analysts fear that if Italy crashed out of the common currency, other weaker economies would be dragged to the exit with it.

The EU's executive arm warned Italy's government in a letter on Thursday that its budget plans appear to violate commitments to reduce its debt and deficit. The fact that Rome has opted to expand its deficit instead of cutting it, and the scale of the deviation from previous promises, "are unprecedented in the history of the Stability and Growth Pact," the Brussels-based European Commission wrote, referring to the EU's fiscal rules.

The government has said it won't change its plans to boost welfare and pension spending and cut taxes, even if the commission launches disciplinary proceedings, which could potentially lead to financial penalties for Italy.

The continuing selloff in Italian bonds challenges government officials' claim that financial markets are more relaxed about their economic policies than Brussels. The bond selloff is also hurting Italy's banking sector, which is heavily exposed to the government's debt.

But despite bouts of anti-euro rhetoric from Rome's antiestablishment government, most analysts see a eurozone breakup as very unlikely.

"The recent [bond market] move is not a European-break-up-driven move," said Mr. Myerberg.

Many investors still expect Rome and Brussels to reach an agreement on the Italian budget. That may take some time, though, meaning bond markets are likely to stay volatile.

"We're looking for a resolution," though it may not come until December, said Adrian Helfert, senior portfolio manager at Amundi.

"There'll be an entry point" to buy Italian debt, he said.

Write to Christopher Whittall at christopher.whittall@wsj.com, Alistair MacDonald at alistair.macdonald@wsj.com and Marcus Walker at marcus.walker@wsj.com

 

(END) Dow Jones Newswires

October 19, 2018 18:53 ET (22:53 GMT)

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