* 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 bond sale
By Emelia Sithole-Matarise
LONDON, Feb 26 (Reuters) - Italian bonds tumbled on Tuesday, dragging other peripheral euro zone debt lower, after an inconclusive election fuelled fears of political instability in the region's third biggest economy.
Ten-year Italian bond yields, which rise as prices fall, surged as much as half a point on the day to 4.86 percent, their highest since mid-December, leading Spanish and Portuguese yields higher.
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.
Traded volume in Italian debt futures was its second 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.
Analysts expected this trend to be mirrored at auctions of up to 6.5 billion euro of five- and 10-year bonds on Wednesday.
Some analysts forecast 10-year Italian yields could hit 5.50 percent -- a level last seen in early September 2012 but still well below levels above 6 percent hit in 2011 which prompted the European Central Bank to start buying Italian and Spanish bonds
"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 48 basis points, its narrowest since June.
They also underperformed Ireland and Portugal, which have been kept afloat by international bailouts since 2010 and 2011 respectively but have managed to slowly regain market confidence with their reform efforts.
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 say.
Few market participants, however, saw Italian yields going back above the 7 percent levels 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.
"It's about valuation, that's what we're focused on and there's a price when these assets become attractive."
In the euro zone's core, the Bund future was 120 ticks higher on the day at 144.71 with the German 10-year yield down 10 basis points at 1.47 percent.
Technical charts point to further gains in the Bund future after the contract broke through 144.30, the 62 percent retracement of the December/January sell-off.
"With the MACD (moving average convergence/divergence) above zero and Monday reflecting fresh bullish sentiment, the risk is for continued upside as an attempt to close the previous unfilled bearish gap from 145.52 and test of the 145.82/146.17 December highs is seen," said UBS technical analyst Richard Adcock.