* Investors dump peripheral debt on fears of Italy gridlock
* Scramble for safety lifts German Bunds to two-month highs
* Italian six-month borrowing costs soar
* Borrowing costs seen jumping at Thursday's Italy bond sale
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Feb 26 (Reuters) - Italy led a sell-off in lower-rated euro zone debt on Tuesday, after an inconclusive election raised the risk of prolonged political instability in the region's third biggest economy.
The threat that Italy's efforts to keep its 2 trillion euro debt burden under control could be derailed as it tries to form a government -- a process that may last months -- could trigger a new wave of contagion in the euro zone crisis, analysts said.
Ten-year Italian bond yields, which rise as prices fall, surged more than half a point on the day to 4.90 percent, their highest since mid-December, leading Spanish and Portuguese yields higher.
It was the fastest daily yield rise since August 2012 -- a pace that some analysts said was a warning for those hunting for high returns by snapping up Italian paper as it cheapened that they might be trying to catch a falling knife.
Safe-haven German Bund futures jumped to their highest in more than two months at 145.07, while U.S. T-note futures rose 10/32 to 132-26/32.
"The longer this political deadlock lasts the more investors will reduce the risk," said Marius Daheim, chief strategist at Bayerische Landesbank. "Investors seem to perceive that this Italian election has the potential to create another wave of risk-off on a global scale."
Traded volume in Italian debt futures was at its highest since the contract was launched in 2009.
Concern at the potential for political deadlock was reflected in a sale of 8.75 billion euros of Italian short-term debt, at which borrowing costs soared to their highest since October.
This trend was expected to be mirrored at auctions of up to 6.5 billion euro of five- and 10-year bonds on Wednesday.
Italian bonds again underperformed Spanish debt, with the 10-year Spanish yield premium over Italy last at 48 basis points, its narrowest since June. Daheim said there was a risk the spread would turn around in the future, with Italian yields trading higher than the Spanish yields.
Italian debt also underperformed Ireland and Portugal, which have been kept afloat by international bailouts since 2010 and 2011 respectively but have managed slowly to regain market confidence with their reform efforts.
OPPORTUNITY TO BUY
The divided parliament and the massive surge of an anti-austerity vote embodied by the meteoric rise of comedian Beppe Grillo's 5-Star Movement and by the success of Silvio Berlusconi's conservative bloc was the worst possible outcome for markets, some analysts said.
Some economists forecast 10-year Italian yields could hit 5.50 percent, a level last seen in September 2012 but still well below rates above 6 percent hit in 2011 which prompted the European Central Bank to start buying Italian and Spanish bonds
Few, however, saw Italian yields going back above the 7 percent peaks scaled in mid-2012, given the backstop of the ECB's pledge to buy bonds at the request of a struggling issuer.
Some said the sell-off in Italian bonds could lure back yield-hungry investors.
"You look at the debt and deficit dynamics and Italy is no worse than a lot of other European countries. On some metrics it's probably even a little better," said Nicholas Gartside, International Chief Investment Officer for Fixed Income at JPMorgan Asset Management which manages $1.4 trillion.
"There's a price when these assets become attractive."