EURO GOVT-Italy rallies but market outlook hinges on election
* Italian bonds make gains awaiting election results
* Exit polls due at 1400 GMT, seen triggering volatility
* Scope for Italian/German spreads to tighten on Bersani win
LONDON, Feb 25 (Reuters) - Italian bond prices rose in thin early trading on Monday awaiting the results of a closely-contested election, with analysts expecting a wave of volatility to hit the market once exit polls emerged later in the day.
Italian 10-year bond yields were 6 basis points lower at 4.39 percent while the safe-haven German Bund future was 18 ticks lower at 143.54, easing away from a one-month high hit on Friday.
The market was expected to remain cautious, and trading volumes low, until around 1400 GMT when the first exit polls from one of the most unpredictable Italian elections in years are expected.
The polls will be seized upon by investors looking to gauge whether the recent positive momentum in the euro zone's third-largest economy is likely to continue under a centre-left coalition, or whether a strong protest vote could produce an unworkable fragmented government.
"We're sitting here waiting for Italian news. The question is how much of the protest vote has there been ... you can argue the more of it that there is, the more likely there's going to be split houses or weak coalitions," a trader said.
Opinion polls give the centre-left coalition led by the veteran former industry minister Pier Luigi Bersani a narrow lead but the race has been thrown open by the prospect of a huge protest vote against austerity policies and rage at a wave of corporate and political scandals.
A win for Bersani's coalition could trigger a 50 to 75 basis point tightening between Italian and German yields according to Goldman Sachs, based on a model that gives a 'fair value' for Italian debt based on economic fundamentals.
The Italian/German 10-year yield spread was last at 281 basis points, around 9 basis points tighter on the day.
A less conclusive result, with no clear winner was expected to see Italian debt underperform German bonds on the ground that any eventual government formed could be unstable and less committed to the economic reforms markets believe necessary.
A third scenario, where former Prime Minister Silvio Berlusconi, who left office in 2011 with Italy on the brink of a full-blown funding crisis, wins influence was seen as the least likely outcome, but the most damaging for Italian debt.
"The outlook for Italian fiscal policy and reforms as well as for further European fiscal integration would be markedly blurred," said Commerzbank strategists in a note.
"This would most likely trigger a massive risk-off shift with Bund set to test new lows for the year below 1.45 percent."
Ten-year Bund yields were last at 1.58 percent, up 1.3 basis points on the day.
The election uncertainty was expected to make a sale of Italian inflation-linked bonds more challenging, but a domestic investor base, seen as a relatively loyal pool of buyers, the auction was unlikely to provide an upset. (Editing by Chris Pizzey, London MPG Desk, +44 (0)207 542-4441)
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