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- Investors require ever higher risk premiums to lend money to Italy

- EU rejects most recent Italian budget package

- Some contagion now seen in Spanish yields

EUR/USD could fall to 1.1300 amidst spiking investor concerns over the Italian budget.

"The dispute over Italy's budget makes it more likely EUR/USD will drop to August's 14-month low of 1.1301 before the month is out," says Robert Howard, an analyst on the Thomson Reuters currency desk.

News on Thursday that the EU had rejected Italy's revised budget proposal for the second time led to a fall in EUR/USD to new lows of 1.1449.

The news also led to a sharp rise in the yield or risk premium bonds investors require to hold Italian government bonds - or lend the Italian government money.

This was reflected in the widening difference between the yield on relatively safe German bunds and Italian government bonds to a five-and-a-half year high of 334 basis points (bps).

Italian yields are rising faster than others as investors start to doubt the fiscal responsibility of the government and its credit-worthiness.

If the spread between Italian and German bonds rises much further - to between 350-400 bps, for example - it will have reached what is considered a "pain threshold" and there will be a marked risk of liquidity drying up and a financial system credit-crunch.

The Commission said Italy's budget appeared to be in "particularly serious non-compliance" with European Union rules," and gave it until next Monday to make revisions and resubmit a new draft.

The Italian government wants to end years of austerity with a popular budget focused on redistribution and increased infrastructure spending, but the EU says its plans are unaffordable and present a financial stability risk.

Italy already has a relatively high debt-to-GDP ratio of 130% and the EU is keen for it to reduce this debt burden - the new populist government's spending plans, however, would mean the opposite, as the state would need to borrow more not less to finance its generous spending commitments.

The main threat to the Euro would come from the onset of 'contagion' as Italy's increasingly punitive borrowing costs spread to other Eurozone neighbouring countries, such as Spain, Portugal or France, as happened in the first Greek debt crisis in 2012.

The risk of contagion, however, has greatly diminished since 2012 and so far the Italian crisis appears relatively well-contained and idiosyncratic.

The lack of spill-over is reflected in the case of Portugal, which recently received a credit upgrade from Moody's.

Yet signs are growing that some form of contagion I starting to spread after the previously 'safe' Spanish bond yield also started rising in sympathy with Italian yields.

The Spanish-to-German spread is still a fair bit lower compared to Italy at 138 bps but there has been a hefty rise in recent days too, reflecting a renewal of contagion fears.

In relation to the single currency, the rise in greater the perceived contagion risks them more likely it is to negatively impact on the Euro's exchange rate and push it lower.

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