Moody's Investors Service on Friday said it may cut Italy's sovereign credit rating from Aa2, citing such challenges as reforming a rigid labor market while also facing the likelihood of rising interest rates.

The review for a possible downgrade of the rating comes amid rising concerns the country will face difficulties in implementing fiscal consolidation plans required to reduce the nation's debt and keep it at affordable levels.

Moody's review of Italy's sovereign rating will focus on the growth prospects for the Italian economy in coming years, and particularly the prospects for a removal of important structural bottlenecks that could hinder a stronger economic recovery in the medium term, the firm said in a statement.

Standard & Poor's has Italy's long-term sovereign foreign currency credit rating two notches lower at A-plus with a negative outlook. Fitch ratings is in between S&P and Moody's with a AA-minus rating and stable outlook.

Moody's announcement came after European markets had closed for the weekend but in late New York trade, the euro trimmed gains against the U.S. dollar, falling to $1.42770 from about $1.43180 before the news. It was last at $1.42830, still up 0.5 percent on the day.

Italy's potential downgrade highlights the tough conditions for some European nations, with Greece having the most acute fiscal problems as it struggles to adopt more fiscal austerity measures.

The Moody's news on Italy reinforces the ECB's concern about the prospect of contagion. And contagion should not happen, said Greg Salvaggio, senior vice president at Tempus Consulting in Washington.

As a result, I think there's a going to be a package put together over the weekend, which is going to effectively offer Greece another lifeline. No one, however, is going to deal with the issue and (they will) simply kick the can down the road.

In its report, Moody's said Italy's economy has long-term structural weaknesses such as low productivity as well as labor and product market rigidities that have impeded growth over the last 10 years.

Italy has so far only recovered a fraction of the nearly seven percentage points in GDP that it lost during the global crisis, despite low interest rates, which are likely to rise in the medium term, Moody's said.

Italy's 10-year government bond spreads narrowed on Friday by 9 basis points to 186 basis points over benchmark German bunds.

Earlier on Friday, Greece's bonds rallied as a tentative agreement by France and Germany on broad steps over how to move forward with a second Greek aid package prompted investors to cash in on recent gains in German bonds.

Greece's 10-year bond yields dropped 95 basis points to 17.53 percent.

Unfortunately, the news flows of European downgrades will only increase the volatility (in) the markets, said David Kelly, chief market strategist at J.P. Morgan Funds in New York.

Greece is in the most financial trouble in Europe ... Other countries including Italy clearly have budget issues. This shows that Europe can't wash its hands of the Greece situation. It must isolate the problem with Greece and help other countries to deal with their fiscal issues, he added.

(Additional reporting by Burton Frierson, Pam Niimi, Richard Leong and Gertrude Chavez-Dreyfuss; Editing by James Dalgleish)

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