UPDATE 1-Italian markets hammered by fears of govt spending binge

* Italian yields set for biggest weekly jump since 2015

Euro dips, Italian stocks drop 1 percent

* Italy's new govt would boost spending, seek review of EU rules

By Dhara Ranasinghe and Helen Reid

LONDON, May 18 (Reuters) - Italy's long-term borrowing costs jumped to more than seven-month highs on Friday while stocks in Milan fell one percent after two anti-establishment parties signed a deal to form a coalition government and pledged to ramp up spending.

After the parties outlined their economic plans, the euro also fell, ceding early-session gains against the dollar.

The agreement between the League and the 5-Star Movement, the two parties that won the most parliamentary seats in an inconclusive March 4 election, have watered down some of their most radical proposals.

But the deal still puts Italy, the euro zone's third biggest economy and one of its indebted states, on a collision course with the European Union and risks further increasing its debt.

That left Italy's bond and stock markets nursing heavy losses after a turbulent week.

"We've had headlines left, right and center from Italy this week and while the upshot is that the reality is not as scary as thought, the investment community is meeting and deliberating their next steps," Commerzbank's head of rates Christoph Rieger said.

"They see the true state of mind of the government and, while the measures don't include debt writedowns, it's clear that there will be no fiscal restraint and no structural reforms for a country that desperately needs it."

Italy's 10-year government bond yield climbed 10 basis points (bps) to 2.22 percent, its highest level since last October. It is up more than 30 bps this week, set for its biggest weekly jump since May 2015.

That left the gap over benchmark 10-year German Bund yields at 159 bps, its widest since early January. Italy also this week became the only euro zone country other than Greece to have two-year borrowing costs above zero.

If implemented as stated and no other government budget item is changed, these policies could lead to a sizable increase in government deficit to approximately 6.5 percent of GDP in 2019, Goldman Sachs said in a note.

This means Italy's debt-to-GDP ratio would increase in 2019 to well above the levels Italy has committed to.

The Italian developments have increased investors' bearishness on the euro which fell 0.2 percent to $1.1778 to approach the five-month low reached on Wednesday of $1.1763.

Options markets show investors are more bearish on the euro over the next six and 12 months than at any time since November though this is also partly down to the dollar's huge rally in recent days.

While euro weakness boosted euro zone stocks, Italian stocks were down more than one percent with banks the biggest drag on the index. The sector sank 2.3 percent to a six-week low.

"We have read the (5-Star/ League government) contract and the big question mark is where are they going to get the money?" Banor SIM head of equities Angelo Meda said.


In a further sign that investors are ratcheting up Italy risk, the cost of insuring Italian debt against a sovereign default kept edging higher.

Sovereign five-year credit default swaps traded at 113 bps, their highest for more than four months, IHS Markit data showed.

Ratings agency DBRS warned on Thursday that economic proposals by Italy's prospective new government could threaten Italy's sovereign credit rating.

DBRS has Italy on a BBB rating - an investment grade score - with a stable outlook.

Analysts said the prospect of increased short-term bond issuance was also causing some concern in bond markets.

The common government policy agenda of Italy's government would include the issuance of short-term government bonds to pay companies owed money by the state, the League's economics chief, Claudio Borghi, said on Friday.

Still, while the Italian/German bond yield spread has widened it remains below peaks seen early last year when investors fretted about euro zone break up risks ahead of the French presidential election.

(Reporting by Dhara Ranasinghe, Sujata Rao, Helen Reid, Tom Finn, Karin Strohecker in London; Danilo Masoni in Milan Editing by Louise Ireland)