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* Investors dump peripheral debt on fears of Italy gridlock
* Scramble for safety lifts German Bunds to two-month highs
* Italian borrowing costs to climb at T-bill auction
By Emelia Sithole-Matarise
LONDON, Feb 26 (Reuters) - Italian bonds tumbled on Tuesday, dragging other peripheral euro zone debt down in their wake, as an inconclusive election fuelled fears of political instability in the region's third biggest economy.
German Bund futures jumped to their highest in two months as investors scrambled for the region's safest debt after a surprisingly large protest vote in Italy left no group with a clear majority in parliament, raising the spectre of gridlock.
Italian 10-year bond yields rose as much as half a percentage point on the day to 4.86 percent, with some analysts forecasting they could hit 5.50 percent -- a level last seen in early September 2012. Spanish and Portuguese yields rose, but less dramatically.
"We have a hung parliament with all the implications for policymaking and reform progress. In that context, Italians have also made it clear that they are not proponents of the austerity and structural adjustment that are necessary for Italy in the medium term," said Michael Leister, a rate strategist at Commerzbank.
"This is a very bad outcome in market terms and this sell-off has more room to go. The market will be looking at new mutli-month highs (for Italian bond yields)."
Italian bonds again underperformed Spanish debt, with the 10-year Spanish yield premium over Italy last at 62 basis points, its narrowest in over four months.
Borrowing costs were set to rise at Italian debt sales this week. Later on Tuesday, the sovereign is scheduled to sell 8.75 billion euros of short-term bills and on Wednesday it auctions 6.5 billion euros of five- and 10-year bonds.
"It's like euro crisis reloaded and the interest Italy will have to pay (to raise funds) is just going to rise and rise," said Charles Berry, a trader at Landesbank Baden-Wurttemberg in Stuttgart.
In the euro zone's core, the Bund future was more than a point higher on the day at 144.52 with the German 10-year yield down 9 basis points at 1.48 percent.