UPDATE 2-Italy's five-year debt costs highest since October
* Italy sells 6.9 bln euros of 5- and 10-yr bonds
* Prolonged political uncertainty, Cyprus fallout hit demand
* Italy's 5-yr debt costs rose to highest in 5 months
* Rumours Moody's will downgrade Italy rattling investors
By Francesca Landini
MILAN, March 27 (Reuters) - Italy paid more to borrow over five years than it has since October at an auction on Wednesday as lack of progress in forming a new government and worries about Cyprus's bailout hit demand, although 10-year costs fell.
The treasury sold 3.91 billion euros ($5 billion) of a new June 2018 bond at a yield of 3.65 percent, more than the 3.59 percent it paid to sell similar paper on Feb. 27, two days after an election in which no party won enough seats to govern.
Borrowing costs had leapt around two-thirds of a percentage point at the February sale on fears that a prolonged political stalemate would stall reforms needed to revive Italy's stagnant economy and address its massive 2 trillion euro debt pile.
Centre-left leader Pier Luigi Bersani has been in talks with rival parties this week to try to form a government, but there is little sign he can muster enough seats to do so and Italians may have to return to the polls, dragging out the uncertainty.
Investors' nerves are also jangling after Monday's bailout deal for Cyprus, which imposed tough conditions including heavy losses for senior bank bondholders and large depositors, and which they fear may become a model for future euro zone rescues.
Persistent market rumours that credit rating agency Moody's is about to downgrade Italy because of the political uncertainty and weak growth outlook have also unsettled investors.
Italy's five-year funding cost on Wednesday was the highest since October, shortly after the European Central Bank pledged to buy bonds of struggling euro zone countries that seek help.
"Overall it looks like a rather weak auction. Volumes seem all right ... but when we turn to the pricing side it looks quite weak," Commerzbank senior strategist Michael Leister said.
Demand was weaker than at previous auctions, with five-year bond drawing bids worth 1.22 times the amount sold versus an average this year of 1.4, and the 10-year bond covered 1.33 times compared with a 2013 average of 1.48.
But Rome paid less than a month ago to sell 3 billion euros of 10-year bonds - 4.66 percent versus 4.83 percent, the lowest level since January - and the auction raised almost the maximum targeted amount of 7 billion euros. Ten-year funding costs had risen sharply in February, immediately after the election.
"The rate on the 10-year bond was in line with the secondary market, while the one on the five-year bond was 2 basis points higher," said ING fixed-income strategist Alessandro Giansanti. "This means that the treasury had to give a discount even after the big fall seen in secondary market prices before the sale."
The yield on Italy's benchmark 10-year bond was about 13 basis points higher on the day at 1430 GMT as its debt underperformed euro zone peers following the sale, which also boosted safe-haven U.S. and German bonds and hit shares. The cost of insuring Italian and Spanish debt against default rose.
The euro slumped to a four-month low against the dollar, hit by the auction and concern about Cyprus, which is finalising capital controls to prevent a run on its banks when they reopen on Thursday for the first time since the bailout. [ID:nL5N0CJ12K}
Grim euro zone economic data reinforced the bearish tone.
Analysts said yields might climb further while the country remains in political limbo, although the ECB's as-yet untested bond-buying pledge continues to provide a powerful backstop.
The stalemate in Rome continued on Wednesday after overtures by Bersani to ex-comic Beppe Grillo's anti-establishment 5-Star Movement were flatly rejected.
Bersani will update President Giorgio Napolitano on his efforts on Thursday. If he cannot secure enough support, Napolitano may appoint a respected outsider to try to form a technocratic government or cross-party coalition, or failing that, call a new election.
"We are in a volatile period that will probably continue. Much depends on the development of the political situation," said Giansanti, adding that Italy was at a "critical moment".
"If the country is not able to form a government in the short-term it will face a high risk to be downgraded by both Moody's and Standard & Poor's, with a negative fallout on the (yield) spread," the analyst said.
The Treasury declined to comment on Wednesday on rumours about a downgrade, while Moody's told Reuters it was watching Bersani's attempts to form a government and its implications for Italy's rating.
The rating firm also warned that the euro zone's awkward handling of Cyprus's bailout had put additional pressure on sovereign ratings in the bloc, including that of Italy.
Moody's rates Italy Baa2, two notches above "junk" grade, with a negative outlook, while Standard & Poor's assigns the country a BBB-plus with negative outlook.
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