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S&P's cut its ratings on the euro zone's third largest economy to A/A-1 from A+/A-1+, judging it less creditworthy than Slovakia, and kept its outlook on negative, warning of a deteriorating growth outlook and damaging political uncertainty.
The euro fell more than half a cent against the dollar before picking up following some reassuring signs from Greece, but bond yields hovered within sight of levels which prompted the European Central Bank to step into the market and buy Italian bonds.
"This is not just more negative news coming out of the euro zone," said Nicholas Spiro, managing director of London-based consultancy Spiro Sovereign Strategy. "This is a confirmation that the world's third-largest bond market, and the euro zone's third-largest economy, is in danger of succumbing to a self-fulfilling loss of confidence."
S&P, which put Italy on review for downgrade in May, said that the outlook for growth was worsening and Prime Minister Silvio Berlusconi's fractious center-right government had not shown it could respond effectively.
Under mounting pressure to cut its 1.9 trillion euro debt pile -- 120 percent of gross domestic product -- the government pushed a 59.8 billion euro austerity plan through parliament last week, pledging to balance its budget by 2013.
But there has been little confidence that the much-revised package of tax hikes and spending cuts, agreed only after repeated chopping and changing, will do anything to address Italy's underlying problem of persistent stagnant growth.
"We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve," S&P's said in a statement.
"Furthermore, what we view as the Italian government's tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy's economic challenges," it said.
Italy has had one of the euro zone's most sluggish economies for a decade and sources said on Monday the government was preparing to cut its growth forecast to 0.7 percent in 2011 from a previous 1.1 percent and for 2012 to "1 percent or below."
"POLITICAL CONSIDERATIONS"
Berlusconi's coalition has been plagued by infighting and policy disagreements and the prime minister himself has been battling a widening prostitution scandal which has distracted the government and badly damaged his personal credibility.
But he lashed out at S&P, saying its move seemed influenced by "political considerations." He said his government had a secure parliamentary majority and was preparing measures to boost growth which would bear fruit in the short to medium term.
"The assessments by Standard & Poor's seem dictated more by newspaper stories than by reality," he said in a statement.
S&P rejected the suggestion that its decision was politically motivated, saying it was based on a detailed analysis of the economy.
The agency said budgetary savings may not be possible because the government is relying heavily on revenue increases in a country that already has a high tax burden and is facing weakening economic growth prospects. In addition, market interest rates are expected to rise, it said.
Berlusconi has been under increasing pressure as the crisis has intensified with groups ranging from business associations to mainstream newspapers and the center-left opposition saying he must act immediately or step down.
Emma Marcegaglia, head of Confindustria, Italy's main employers federation, said business was tired of being treated as an "international laughing stock."
"The government must either adopt immediate, serious and also unpopular reforms or else, I am not afraid to say it, it must pack its bags and resign," she said.
Italy's Economy Minister Giulio Tremonti was holding talks at the treasury following the agency's decision. S&P will host a conference call to explain the move later on Tuesday.
RATINGS "DICTATORSHIP"
S&P's move drew a mixed response from Italy's European partners with French Foreign Minister Alain Juppe repeating longstanding criticisms of the international ratings agencies.
"We should not cave in under this dictatorship of ratings agencies, whose transparency is in serious need of improvement," he told Europe 1 radio.
However, Peter Altmaier, a senior parliamentarian in Chancellor Angela Merkel's center-right coalition saying it demonstrated the need for governments to show responsibility.
Financial markets had been expecting rival agency Moody's to move first, after it put Italy on review in June. It said last week it would decide within a month whether to cut its rating but declined to comment on Tuesday.
S&P's rating is now three notches below Moody's and puts Italy below Slovakia and level with Malta.
"The rating downgrade was not totally unexpected, even though it came from the agency we didn't expect," said Paola Biraschi, banking analyst at RBS in London.
"To me it seems like a competition between rating agencies to publish the downgrade first," she said.
Italy's stock market weakened initially but turned positive as other European markets headed higher on short-covering after heavy losses on Monday and as some dealers said markets had already priced in the downgrade.
Italian 10-year government bond yields rose to more than 5.6 percent while spreads over German bunds widened to more than 386 basis points.
The cost of insuring against an Italian default has also risen sharply, with Italian 5-year credit default swaps above the psychologically important 500 level at 508 basis points on Tuesday morning, according to monitor Markit.
Only the European Central Bank, which has been buying Italian bonds to prop up the market, has kept Rome's borrowing costs from spiraling out of control, but yields have crept back up steadily since the ECB stepped into the market in August.
"Italy is now struck in a self-fulfilling downward spiral from which it is unlikely to be able to extract itself without external help," said Sony Kapoor, of Brussels-based think tank Re-Define.
"Without full confidence in the credit-worthiness of Italy, it's impossible to have full confidence in the solvency of the European banking system," he said.
(Additional reporting by Wayne Cole in Sydney, Daniel Bases and Burton Frierson in New York, Michel Rose in Milan and Giuseppe Fonte in Rome; editing by Ron Askew)
Copyright 2011 Thomson Reuters.
