Italian stocks tumbled with the FTSE MIB dropping 2.3% - the worst performer among major European markets on Monday - and hitting its lowest level since April 2017, while the country's bonds plunged to the lowest level since February 2014 amid what now appears to be an inevitable showdown between Italy and the EU, after the European Commission said Italy’s budget plans are in breach of common rules.

Over the weekend, the European Commission told Italy it is concerned about its budget deficit plans for the next three years since they breach what the EU asked the country to do in July, but a defiant Rome insisted on Saturday it would “not retreat” from its spending plans.

In a letter to Italy’s Economy Minister Giovanni Tria, the Commission said that with a planned headline deficit of 2.4 percent of GDP in 2019, Italy’s structural deficit, which excludes one-offs and business cycle effects, would rise by 0.8 percent of GDP. Under EU rules Italy, which has a public debt to GDP ratio of 133 percent and the highest debt servicing costs in Europe, should cut the structural deficit every year until balance.

“Italy’s revised budgetary targets appear prima facie to point to a significant deviation from the fiscal path” commonly agreed by European Union governments, EU Commissioners Valdis Dombrovskis and Pierre Moscovici wrote in a letter to Italian Finance Minister Giovanni Tria. “This is therefore a source of serious concern,” the commission’s finance chiefs said in their letter Friday responding to a note sent by Tria the day before.

“We call on the Italian authorities to ensure that the Draft Budgetary Plan will be in compliance with the common fiscal rules,” the letter added at the same time as the council of EU ministers asked Italy in July to reduce that structural deficit by 0.6% of GDP next year, which means the deficit would be 1.4 points off track, Reuters reported.

The criticism was shrugged off by Italian Deputy Prime Minister Luigi Di Maio, who said his government will stick to its deficit targets before next year’s EU Parliament elections usher in lawmakers fed up with austerity and ready to relax budget rules.

“It needs to be clear that we are not going to go back because as far as I’m concerned, these measures are not meant to challenge Brussels or the markets, but they need to compensate the Italian people for many wrongs,” Deputy Prime Minister and 5-Star leader Luigi Di Maio told journalists at an event in Rome. "There is no plan B because we will not retreat. We will explain the reasons for these measures ... but we are not going back," he said.

"There will be such an earthquake in all countries against the austerity that the rules will change the day after the elections," Di Maio, who’s also the head of the Five Star Movement, said in an interview with Corriere della Sera published on Sunday. He was referring to the need for the EU countries to reduce deficits under existing regulations.

For now, however, the only earthquake is the one hitting Italian markets with the FTSE MIB sliding as much as 2.3%...

... with Italian banks getting slammed:

UNICREDIT HALTED, LIMIT DOWN AFTER FALLING 5% IN MILAN

UBI HALTED, LIMIT DOWN AFTER FALLING 5% IN MILAN

MEDIOBANCA HALTED, LIMIT DOWN AFTER FALLING 5% IN MILAN

... while Italian 10Y BTP tumbled to new cycle lows, with the yield on the benchmark security rising above the May selloff highs, rising as high as 3.625% from a Friday close of 3.42%, a level not seen since February 2014. Italian bonds bear flattened with 2y yield climbing as much as 30bps to 1.636% as 10y yields broke above 3.6%. At the same time, the December BTP futures touched a new low since becoming the active contract.

Meanwhile, the 10-year BTP/bund spread has blown out to 308bps, the widest level since May 2013.

While the ball is now in Brussels’ court, "lowering the deficit targets for 2020 and 2021 shows willingness by the Italian government to seek a deal," HSBC Economist Fabio Balboni says in note. "The EC should also be wary of possible rising euro-scepticism in Italy, especially ahead of European parliamentary elections next May. So, we think there is room for negotiation. But, even then, given higher deficits, Italy’s debt trajectory remains precarious" he added.

The war of words continued on Monday, when Italian Deputy Premier Matteo Salvini said that "we are against the enemies of Europe which are Juncker and Moscovici, closed in the Brussels bunker," and that the "EU Parliament elections in May 2019 are a chance to "save" at a joint press conference in Rome with Marine Le Pen, testing the EU’s resolve.

As a result of this strong anti-EU rhetoric, contagion has re-emerged with the Swiss franc is marching higher after the statements by Salvini and Le Pen. As Bloomberg notes, this type of talk will concern investors, who were of the impression that cooler heads might prevail and Italy would adopt a more conciliatory tone.

At 308bps, the 10-year BTP/bund spread is at the widest level since May 2013. For now the Italian deputy leader's words are rattling markets. At some point, though, Salvini's rhetoric will have to face up to the reality of Italy's borrowing costs being too expensive to deliver on his promises.

At some point yes, but for there are few catalysts to halt the selloff as Wall Street strategists have turned increasingly bearish on BTPs, with Morgan Stanley, Societe Generale and Citigroup all bearish and warning that a ratings downgrades will be the next emerging theme.

And until then, look for fears about Italy's budget, and rising redenomination concerns to pressure the Euro which broke 1.15 support, dropping to a low ot 1.1471, the lowest level since mid-August...

... as Europe's artificial stability once again appears to be on the brink.