UPDATE 4-Italian bonds hit by concerns EU may reject budget plan

A recovery in Italy's bond market fizzled out on Wednesday, with yields rising once again - this time on a report that the EU will say the draft Italian budget does not meet the bloc's guidelines, news of fresh supply and a selloff in risk assets.

Having fallen in the past two sessions as well as opening lower on Wednesday, Italian government bond yields were 3 to 8 basis points higher across the curve.

European Commissioner Guenther Oettinger said Italy's draft budget for 2019 was not in line with European Union guidelines, according to German magazine Der Spiegel, reviving concerns about a clash between the EU and Rome over the Italian government's expansionary fiscal plans.

"The story has ignited some fear back into the market," said Jean-Christophe Marchado, a fixed-income strategist at Natixis.

Earlier in the day, Italy announced a bond buyback, combined with a reopening of several long-dated bonds in a bond exchange deal due later this week.

While buybacks tend to boost the Italian market, the announcement that this will take place with a tap of existing bonds put upward pressure on long-dated yields.

The selloff in long-dated debt extended to shorter-dated maturities after the Der Spiegel report and as stock markets globally sold off, denting appetite for risk assets in general.

Italy's 10-year government bond yield was up 8 bps at 3.54 per cent, pushing the gap over German Bund yields back above 300 basis points.

Two-year Italian bond yields were 3.5 bps higher at 1.63 per cent, having given up earlier falls.

Rome officially approved an expansionary budget on Monday, but markets were relieved that Economy Minister Giovanni Tria remained in office, prompting a recovery in Italian bonds.

Next year's projected deficit of 2.4 per cent of output is well below the EU's 3 per cent ceiling - a policy to discourage member states from going down a path of unsustainable spending - but it is up sharply from a targeted 1.8 per cent this year.

This contravenes EU regulations that call on Italy and other highly indebted countries to steadily narrow the shortfall towards zero.

Last week, many appeared to be positioning for worse news on the budget front, with data suggesting investors were going heavily short on Italian debt, said UniCredit rates strategist Luca Cazzulani.

Thomson Reuters data shows that open interest in short-dated BTP futures was at its highest in over a year on Oct. 11, and remained elevated for the rest of the week.

"The fact that you had such high open interest at a time of dropping bond prices suggests that a lot of shorts were coming into the market," said Cazzulani. "With the absence of any negative news this week, some of that will come out."

As risk aversion returned to financial markets, yields on safe-haven German 10-year bonds fell to a two-week low of 0.45 per cent.

Two-year German yields hit a six-week low of minus 0.6160 per cent, pushing the gap over U.S. peers to its widest in 30 years.

(With inputs from agencies.)