UPDATE 6-Italian bonds, shares hammered banks in Rome, the EU draws battle lines for the budget

* 10-year construction performance peaking in one-and-a-half years, yield of 2 years up to 25 basis points

* Italian stocks are the lowest since April 2017, banks are collapsing

* The EU raises concerns about the Italian budget; Rome defying

* ECB's node: The timing of the ECB rate hike has not been fixed (price of updates)

By Dhara Ranasinghe and Danilo Masoni

LONDON / MILAN, Oct 8 (Reuters) – Italy's borrowing costs soared on Monday, stocks of banks fell and the euro weakened with the war of words between Rome and the European Union concerning the Italian draft budgets.

While Italian bond yields jumped by 30 basis points, the Italian-German 10-year bond yield spread – a closely monitored measure of country risk – exploded to more than 300 basis points.

This had repercussions on all markets: the Italian stock market reached its lowest level since April 2017, bank stocks fell by 4% and the euro weakened.

Italian Deputy Prime Minister Matteo Salvini, at a press conference with French far-right leader Marine Le Pen, denounced Monday the President of the European Commission, Jean-Claude Juncker, and the Commissioner of the Economy, Pierre Moscovici, as enemies of Europe.

The Commission told Italy that it was concerned about its budget deficit plans for the next three years, as they violate what the EU asked the country to do in July.

Salvini also said on Monday that Italy would not give in to market pressure and would not go back on its plan to increase the budget deficit next year.

"The war of words reinforces the belief that we are going to have a fiscal conflict between Italy and the European Union," said Martin van Vliet, strategist in charge of rates at ING.

"Salvini is clear that they do not intend to return to the drawing board."

Rome must submit its draft budget to the Commission, which will check if it complies with EU rules, by 15 October.

The 10-year Italian bond yield reached its highest level since the beginning of 2014 at 3.63%, before closing at 3.59%; Two-year yields rose 30 basis points to a four-month high of 1.656% before rising to 1.57%.

Analysts have noted a strong sell of short-term Italian notes as another sign of market malaise. The yield of a nine-month Italian Treasury rose 25 basis points to 0.87% at one point.

The Italian-Spanish yield spread was widest for more than 20 years at 203 basis points, while the price of five-year Italian credit default swaps increased by 10 basis points the day to 274 points basic.

The turmoil in the Italian market spurred the higher-rated bonds, which were under pressure last week because of the strength of US data and expectations of a rise in US interest rates.

Even the hawkish comments of the Dutch central bank Klaas Knot have failed to curb the recovery in so-called "core" bond markets.

The European Central Bank will begin talks on the timing of a rise in interest rates in January, Knot said.

German 10-year yields fell 3 basis points to 0.53% from the 4-month high of last week.

"We are a little surprised by the strength of the reaction in the bond markets, but it seems that the market is concluding that the European Commission will adopt a tough position when Italy submits its budget," said Antoine Bouvet, strategist in charge of key rates in Mizuho.

BANK WOES

The single European currency fell by almost 0.5% against the dollar. It fell 0.5% against the Swiss franc, its biggest daily drop in a month.

The defeat of bonds has dealt a new blow to Italian banks.

National government bonds account for 10% of the total assets of Italian banks, making them vulnerable to an increase in the cost of Rome's debt.

The shares of Intesa Sanpaolo, one of the largest banks in Italy, fell by 3.3%. UniCredit dropped 3.6%, driving the Italian stock market down 2.4% on a day when the largest European stocks fell by 1.1%.

The Italian stock market index is now trading at a lower selling price compared to euro-zone equities than during the Euro debt crisis, suggesting that the Rome budget difficulties are particularly damaging to Italian companies . Cheap valuations could, however, eventually attract investors looking for good deals.

Italy's multi-year expansionary fiscal plan released on Thursday night could turn against the populist government, say analysts, who see a risk of rising borrowing costs and deteriorating ratings.

Salvini said that he hoped the rating agencies would show no prejudice towards Italy. He again ruled out an exit from the euro.

"The euro zone without Italy is not something I could see," said Talib Sheikh, director of the Jupiter Flexible Income Fund.

Moody's, who has a negative outlook on Italy's Baa2 rating, said it would deliver its verdict by the end of October. S & P must review its rating for Italy on October 26th.