Messy election outcome to weigh on Italian markets
* Italian bonds, shares seen falling on political gridlock
* Vote for upper house deadlocked
* "Worst possible outcome for markets" - analyst
MILAN, Feb 26 (Reuters) - Italian bonds and shares were set to fall on Tuesday as a messy election result fuelled fears of a hung parliament and an ungovernable country.
A huge protest vote on Monday by Italians enraged by economic hardship and political corruption pushed the country towards deadlock, with no coalition likely to be strong enough to form a government.
Italy's centre-left said it had won the lower house but no party or coalition appeared to be in a position to take a majority in the upper house or Senate.
A grid locked parliament will dismay investors hoping for strong leadership to lead the eurozone's third largest economy through a deep recession, rising unemployment and a massive public debt.
"This is the worst possible outcome from the market's point of view, and I can't see how BTP bond prices can avoid losing ground," said Alessandro Tentori, Citi head of global rates.
"It seems inevitable that there will be a new election. What worries me most is the success of Beppe Grillo and the high abstention rate - basically half of the country is sick of the old political system and change will only come painfully."
Comedian Grillo's anti-establishment 5-Star Movement was the big surprise of the election, winning around 25 percent of the vote thanks to the disdain many Italians feel for established parties.
Outgoing Prime Minister Mario Monti said all parties had a responsibility to ensure a government could be formed.
FEARS SPREAD AROUND GLOBE
Fears of a political stalemate that could re-ignite the euro zone debt crisis resonated well beyond Italy's borders, with the euro falling to a more than six-week low against the dollar in volatile trade late on Monday.
Italian markets had a rollercoaster ride on Monday, with bonds rising and shares soaring after initial telephone polls showed the country's reform-minded centre-left coalition with a slim lead.
Subsequent projections showed a stronger than expected performance by the centre-right, led by former prime minister Silvio Berlusconi, raising the spectre of parliamentary paralysis.
The blue-chip index closed up 0.7 percent, having been four percent higher at one point.
Italy faces crucial bond sales this week.
It will sell 8.75 billion euros of six-month bills on Tuesday. On the grey market on Monday evening, those bills traded with a yield of 0.85 percent, up from a 0.73 percent rate at a similar sale one month ago.
More important for debt markets is the test on Wednesday, when the Treasury will offer between 3 billion and 4 billion euros of a new 10-year bond and between 1.75 and 2.5 billion euros of five-year paper.
"The Italian/German yield spread could rise to 320-330 basis points and towards 350 bps on Wednesday. The 10-year bond will likely see a bigger rise in yield at Wednesday's auction," said Raj Badiani, economist at IHS Global Insight.
"I expect that in the next 2-3 months we will see a bumpy political ride," he said. The premium investors demand to hold 10-year Italian government bonds over equivalent German Bunds stood at 283 basis points at the market close on Monday.
Shares are also expected to take a hit, with traders noting volumes on the stock market futures were very heavy on Monday.
"If the results confirm the trend we have seen, we find ourselves in a situation where the country is ungovernable. There is huge uncertainty, even if you think there'll be another election in June," said a Milan bourse trader.
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