5 Min Read
* MSCI World index down 0.6 pct
* Euro hits 7-week low before recovering
* Italian bond yields rise by most this year
* U.S. stocks seen higher as Bernanke testimony eyed
By Richard Hubbard
LONDON, Feb 26 (Reuters) - World stock markets and southern European government bonds sank on Tuesday on fears that political gridlock in Italy would leave its economic reforms in tatters and reignite the euro zone's broader debt crisis.
However, U.S. stocks, which fell in reaction to the Italian election outcome on Monday, were poised to open higher, with investors awaiting testimony by Federal Reserve Chairman Ben Bernanke on future policy direction.
But the uncertainty generated by the Italian poll was still rattling most other major risk asset markets, with Italy's 10-year bond yields, which rise as prices fall, up as much as half a point to 4.86 percent, their highest since mid-December.
Investors also sold Spanish and Portuguese debt and sent Brent crude oil prices down to $113 barrel, their lowest level in a month, while safe-haven assets like gold and German government bonds rallied.
"The main driver now is the deadlock after the Italian election - it's triggered risk-off sentiment in the financial markets," said Carsten Fritsch, commodity research analyst at Commerzbank in Frankfurt.
Investors are fearful that the strength of the vote for anti-austerity parties at the election will weaken efforts to reform Italy's public finances and its labour laws, damaging the euro zone's efforts to resolve its three-year old debt crisis.
"What's important is to understand if, in fact, this (vote) against austerity is also against reform, which clearly is still very important to Europe, and to Germany as well, with the elections coming in September," said Virginie Maisonneuve, head of Global Equities at Schroder Investment Management.
Last year's promise by the European Central Bank to provide unlimited support to struggling euro zone nations provided some reassurance to investors, allowing many to wait for greater clarification on Italy's next step.
"A lot of our clients are in a 'wait and see' mode looking to sit on their current holdings to see how the situation develops," said Lyn Graham-Taylor, fixed-income strategist at Rabobank.
"Obviously they will become active once the political situation becomes clearer," he said.
Italy and Spain's need to change the shape of their economies, get growth going and debt down have been at the heart of the euro zone's troubles for more than a year, but the fears have eased substantially since the ECB made its support clear.
The uncertainty weighed on European share markets, dragging the pan-European FTSEurofirst 300 index down nearly 1 percent. London's FTSE 100 was down 1.25 percent, while Paris's CAC-40 and Frankfurt's DAX were down as much as 1.7 percent.
MSCI's broadest index of Asia-Pacific shares outside Japan fell 0.9 percent, sending the MSCI world equity index down 0.6 percent to 349.1 points.
The inconclusive outcome in Italy cast a further shadow over the euro, which had hit a high of $1.37 at the start of the month before steadily losing ground as economic data showed the region's economy still struggling.
The euro traded around $1.3050 on Tuesday, just above seven-week lows, while against the yen its was up 0.4 percent at 120.39 yen.
"We have seen a cautious bounce (in the euro), but it doesn't look like we are seeing anything durable here," said Jeremy Stretch, head of currency strategy at CIBC.
Investors were also nervous before testimony later in the day from U.S. Federal Reserve Chairman Ben Bernanke, who could give further clues to when the central bank intends to slow down or stop its bond-buying programme.
Financial markets were rattled last week when minutes of the Fed's January meeting showed some officials were thinking of scaling back its monetary stimulus earlier than expected.
Also of concern to many is the darkening outlook for global growth, with sharp budget cuts due to take effect in the United States on Friday, and weak data from China revealing a growing slowdown in its export-oriented manufacturing sector.
The uncertainty has led to a sharp rise in volatility, with the CBOE's widely watched Vix Index jumping 34 percent on Monday for its biggest one day gain since August 2011.
Europe's equivalent index, the VSTOXX, which reflects options pricing and demand to protect against falls in the underlying cash market, rose 15 percent on Tuesday to hit a new year's high of 24.73.