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Italy's government bond yields spiked to multi-year highs Friday, while banks stocks tumbled and risk premia increased, after European Union officials rejected Rome's 2019 budget proposals and coalition government leaders squabbled over proposed changes in domestic tax law.

The European Commission said Italy's near-term budget plans, which anticipate a 2.4% deficit and billions in new spending, were an "unprecedented" violation of EU rules and urged the government to revisit certain campaign promises in order to put the country's finances, which include a debt-to-GDP ratio of 132%, on a firmer footing.

The concern was compounded by comments from European Central Bank President Mario Draghi, who reportedly told EU leaders that there is "no evidence that to undermine all the rules will lead to prosperity, but it will carry a high price tag for all actors" and urged that "rules must be respected in the self-interest of all parties, especially the weaker ones", suggesting the Bank may not act as swiftly as usual if Italian government bond yields rise and domestic financial liquidity is stretched.

Italy's benchmark 10-year bond yields hit 3.75% in early Friday dealing, the highest since 2014, while the FTSE Italia Banks index fell 3.3% at the start of trading in Milan. The extra yield, or spread, that investors demand to hold Italian government debt instead of triple-A rate German bunds rose to 3.4%, the widest in at least five-and-a-half years.

Reports of a rift between Deputy Prime Ministers Matteo Salvini, who leads the right wing Liga Movement, and Luigi Di Maio, head of the leftist Five Start Movement party, over a budget clause that would accept a small "amnesty" settlement from businesses, as it traditional in Italian politics, in lieu of the full payment of back taxes. 

Salvini told the  Il Messaggero newspaper Friday that their is no crisis in the current coalition government, but Prime Minister Giuseppe Conte is set to convene a meeting between the two side Saturday in order to hammer out a collective position in order to face down EU leaders in Brussels, who want new spending proposals by October 22.

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The euro was marked 0.3% lower against the U.S. dollar in early European trading and changing hands at 1.1448 following news of the tax law dispute and Brussels' rejection of the budget plan late Thursday.

"While a clear non-positive for the euro, the spillover into the common currency has been fairly limited partly because the disagreement over the path of the Italian budget has been widely expected," ING analysts wrote. "In other words, a fair degree of negative news relating to Italy seems to be in the price, hence the relatively mild pace of EUR decline."

However, the bond market moves, the extra borrowing costs they'll incur for the government and the stress they'll apply to the nation's banking system are likely bigger market concerns over the near term.

Italian government bonds are estimated to comprise around 11% of total banking sector assets, a figure that matches the 2015 and makes them extremely sensitive to interest rate movements and negative fiscal headlines.

That pressure is growing, as well, as the European Central Bank continues to signal the end of its bond-buying program, which has taken some €350 billion in Italian government debt since its launch in March 2015.

Italy's current coalition government, a collection of far-left and far right anti-European political movements, is ostensibly led by Conte, but is more practically dictated by Di Maio and Salvini.

Despite their stark political differences, both men have found common cause -- and domestic popularity -- in their mutual distaste for the European Union and its perceived control over Italy's internal finances and the pair have attempted to build public support with a deficit busting budget that would fund social welfare projects and deliver broad tax cuts.