- Officials from the European Union (EU) and Italy have found themselves in a deadlock after the former's economic forecasts showed the Italian economy would grow at a slower pace in the next two years than Rome thinks.
- But, the big question in front of investors is how the markets will react to this noise.
Brussels and Rome are in a constant back and forth over budget negotiations but analysts told CNBC that it is the markets that matter the most.
Officials from the European Union (EU) and Italy have found themselves in a deadlock after the former's economic forecasts showed the Italian economy would grow at a slower pace in the next two years than Rome thinks.
The Italian government was quick to dismiss, blaming the EU for its "inadequate and partial" analysis of the country's spending plans.
These comments came after Brussels said earlier on the day that Italy's 2019 deficit will reach 2.9 percent and not 2.4 percent as Rome insists. Both sides have clashed over Italy's 2019 budget plans after the anti-establishment government promised to increase spending, challenging European fiscal rules.
On Friday, Italy's Economy Minister Giovanni Tria said Brussels' proposed deficit cuts would be "suicide" for the country's economy. The unyielding stance from Rome triggered a rise in the yield spread between German and Italian debt, a common measure of risk for European investors.
Analysts told CNBC the standoff looks set to continue, and that the EU is laying the ground to open the process that could eventually lead to sanctions — though no EU country has ever been fined for breaching spending limits.
But, the big question in front of investors is how the markets will react to this noise.
"Continued pressure from the EU, further ratings downgrades and even higher risk spreads will force Rome to soften its policies by just enough in coming months to stave off an immediate debt crisis," Florian Hense, economist at Berenberg told CNBC Friday in an email.
Yields on Italian debt have risen significantly since May — when the two populist parties, Five Star Movement and Lega, joined forces to form the next cabinet. Investors have fretted about the government's spending plans given that Italy has a massive debt pile — the second largest in the EU at about 130 percent of gross domestic product.
In the last seven days alone, the yield on the 10-year Italian bond is up by about 12 basis points. Looking at its performance throughout the year, there has been an increase of about 172 basis points.
"The true guardians of fiscal discipline will be, as usual, financial markets," Lorenzo Codogno, chief economist at LC Macro Advisors said in a note to clients Thursday.
Rising interest rates pose risks to the Italian economy. Not only the government could face difficulties in funding itself in the markets, as there could be additional pressure on the Italian banking system.
Italian lenders have about 10 percent of sovereign bonds and higher yields mean that the chances of seeing a return on their Italian bonds are reduced, exposing bondholders to risk. The FTSE Italy banking index is down about 36 percent from a peak on April 24.
David Roche, global strategist and the research firm Independent Strategy, told CNBC Friday that Italy will continue pushing the string until it gets close to leaving the euro zone.
"What will change is when Italy's budget arithmetic gets it to the edge of the cliff of leaving the euro and populists have to ask their voters, okay do you want to jump — and then I think the Italian people do not want to leave the euro," he told CNBC's "Squawk Box Europe."
"But we have a road to travel."
The European Commission has given Italy until next Tuesday to update its 2019 budget plans, in a way that reduces the economic risks. However, until now, Rome has not signalled any intentions to change its plans.
"The budget plans of the Italian government are a far cry from EU fiscal rules," Hense said in a note.
"So far, the ruling coalition in Rome has stubbornly rejected EU demands to change its budget plans. In combination with the reversal of structural reforms, Italy's fiscal plans have caused an unprecedented clash between the third largest EU27 member state and the rest of the EU."