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GLOBAL MARKETS-Stocks rally cut off by EU threats over Italy's budget

Virginia Furness

* Graphic: World FX rates in 2019 http://tmsnrt.rs/2egbfVh

LONDON, May 28 (Reuters) - European stocks, bond yields and the euro fell on Tuesday as concern about Italy's budget overshadowed talks of a Fiat-Chrysler and Renault merger and the muted showing of nationalists in European Union parliamentary elections.

After gains in Asia, hopes that European stocks would open higher were dashed, with Italian shares falling more than half a percent, unwinding early gains in both the pan-regional STOXX 600 and Germany's DAX.

Markets had been cheered by limited gains for nationalists in the EU elections, though wins for eurosceptic parties in Italy, France, Poland and would-be ex-member Britain, as well as snap elections in Greece and political turmoil in Austria, curbed risk appetite.

However, Italy's dispute with the European Commission emerged to dominate European trading as markets opened. The Commission could fine Italy 3 billion euros for accumulating debt and deficits that break EU rules, Italian Deputy Prime Minister Matteo Salvini said on Tuesday.

"It reopens the whole agenda of whether Salvini wants to be part of the euro or not," said Colin Harte, a portfolio manager and strategist at BNP Paribas Asset Management.

"The danger is that the 1/8dispute between Salvini and the EU 3/8 turns out to be more aggressive on both sides, then you will see people switch out of positions 3/8," Harte said.

The spread of Italian 10-year debt over top-rated Germany reached around 100 basis points between mid-October and mid-March, but since then has blown out to 285 basis points .

German government bond yields, deemed the region's safest asset, fell four basis points to a two-and-a-half-year low. The euro weakened 0.11% against the dollar.

U.S. yields were also lower. Benchmark 10-year Treasury notes yielded 2.27%, down five basis points. TRADE TALKS KEEPS THINGS TIGHT Trade worries remained high. U.S. President Donald Trump said on Monday that Washington was not ready to make a deal with China, but he expected one in the future. At the same time, he pressed Japanese Prime Minister Shinzo Abe to reduce Japan's trade imbalance with the United States.

Hope for a U.S. - China trade agreement still underpins optimism in global markets, but U.S. 500 e-mini futures were down almost 0.25 percent.

"Markets are holding their nerve and will start to attach great hope to the meeting between Presidents Xi and Trump in June," said BNP Paribas's Harte. "But I'm not as convinced that Trump wants a deal."

"The big risk is that the U.S. starts being disruptive to supply chains ... and the big problem is we don't really understand how much damage this will do."

Asian shares rose, lifted by advances in China and gains by auto firms after Fiat Chrysler FCHA.MI made a "transformative merger" proposal to French peer Renault.

Auto stocks rose globally rose after Fiat Chrysler confirmed it had made proposed a merger with Renault, a deal that would create the world's third-biggest carmaker. The rally spilled into Asia with Mitsubishi Motors Corp 7211.T in Japan adding 5.95% and Nissan Motor Co 7201.T gaining 2.31%.

A planned increase in the weighting of Chinese A-shares in MSCI indexes after the market closes on Tuesday also boosted shares.

The dollar index .DXY, which tracks the U.S. currency against a basket of six other major currencies, rose 0.15% higher at 97.747.

In commodity markets, oil prices extended gains after rising more than 1% on Monday. Prices rose on tensions in the Middle East and continuing Russian supply disruptions after a contamination problem discovered last month.

Brent crude was 0.29% higher at $70.31 per barrel, having earlier dipped below the $70 mark. U.S. West Texas Intermediate crude gained 1.16% to $59.31 per barrel. (Reporting by Virginia Furness; additional reporting by Silvia Aloisi in ROME;)