Italy’s bond yields jumped and the euro dropped after the EU said the country’s deficit assumptions would breach its 3.0% limit by 2020.

In a report released as part of its overview of the European economy, the EU warned Rome’s growth estimates were too optimistic and that the deficit would widen to 2.9% next year, far above the government’s 2.4% target. The deficit would then rise above the bloc’s 3% limit in 2020.

The report marks the latest shot in the ongoing standoff between Brussels and Rome over Italy's expansionary budget. While Italy's government says it needs to support an economy that’s underperformed the euro area for years, the EU and investors are worried what it will do to the country’s mountain of debt, the second largest as a percentage of GDP in Europe after Greece.

In the report, the European Commission forecasts:

• GDP growth of 1.2% next year, well below the government’s target of 1.5%
• The decline in GDP has implications for the budget deficit, which is now seen widening to 2.9% next year and 3.1% the following year.
• The government’s targeted 2.4% deficit for 2019 was flatly rejected by the commission.

The EU said the growth outlook is subject to “high uncertainty amid intensified downside risks,” including a further jump in government borrowing costs. Italy’s ongoing deficit standoff has already sent Italian bond yields to a four-year high.

Given the “fiscal deterioration” and risks to growth, the EU also warned Italy’s large debt-to-GDP ratio won’t decline through 2020, refuting Italy's optimistic predictions of a decline in debt/GDP.

“We need to get closer together, but we need to respect the rules,” Moscovici told reporters in Brussels. “We would like Italy to remain what it is -- a major country within the euro zone. There’s no future for Italy outside the euro zone.”

The commission also warned about the impact of higher debt-financing costs on lenders, singling out Italy as one of the “high-debt euro area countries” where “disruptive sovereign-bank loops could also re-emerge in case of doubts about the quality and sustainability of public finances.” As Bloomberg notes, "while the EU’s forecast language is gloomy, the reality may turn out to be worse."

“Even the EU forecasts themselves look too optimistic,” said Lorenzo Codogno, visiting professor at London School of Economics and a former chief economist at the Italian finance ministry. “The impact of higher borrowing costs on the banks’ loan rates is set to limit economic growth even further.”

The EU wants Rome’s budget plans revised, but the government is refusing to yield. Finance Minister Giovanni Tria signaled this week that the government is not ready to budge on its controversial budget even as his euro-area counterparts called on Italy to prepare revised spending plans.

To keep negotiations alive, Tria told reporters after a Monday meeting in Brussels that the government will pursue a dialogue with the Commission. In setting the Nov. 13 deadline for a resubmitted budget, the commission said the original plan constituted a clear deviation from EU rules. Tria will meet on Friday in Rome with Portugal’s Mario Centeno, the head of the Eurogroup of finance ministers.

After the release of the report, yields on Italian bonds extended an increase this week, rising above 3.40% on Thursday morning, with the spread over those on their German peers climbing five basis points to 294 basis points.

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“The sentiment is obviously negative for Italian bonds,” said Arne Lohmann Rasmussen, head of fixed-income research at Danske Bank A/S. “Things are of course heating up ahead of the deadline on Tuesday.”

Still, it was not all bad news: further disagreement with Italy is already “widely expected” by the market and there is still scope for improvement in sentiment toward the nation’s bonds, according to Mizuho International Plc. “We’re not expecting much of a sell-off in BTPs beyond a short-term ‘knee-jerk’ reaction,” wrote strategists Peter Chatwell and Antoine Bouvet in a note to clients. They recommended buying five-year bonds versus their two- and eight-year peers.