May 21, 2018 / 2:08 PM / 5 months ago

UPDATE 4-Italian markets extend selloff on prospect of high-spending new government

* Italian yields soar; Italy-Spain yield gap widest in six years

* Investors fret over coalition plans by League and 5-Star

* Italy’s stock market down, broader European market up

* Euro also on back foot, falls vs dollar, Swiss franc

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (updates prices, adds bank stocks, quote)

By Dhara Ranasinghe and Danilo Masoni

LONDON/MILAN, May 21 (Reuters) - Italy’s borrowing costs surged again on Monday and its stock market touched six-week lows as two anti-establishment parties that plan to ramp up spending appeared set to form a coalition government.

The 5-Star Movement and League will seek the president’s backing later in the day for their choice of prime minister, expected to be Giuseppe Conte, a university professor. He would lead a coalition seeking billions of euros in tax cuts, additional welfare spending and a roll-back of pension reforms.

The prospect of a spendthrift government taking shape in Italy, the euro zone’s third-biggest economy and its most indebted after Greece, has rattled markets.

Italian two-year bond yields jumped 19 basis points to 0.27 percent, their highest since December 2016. A week ago, that yield was at minus 0.11 percent.

The gap between 10-year Italian and Spanish bond yields was at 82 basis points, having widened from 50 bps at the end of April. The spread is now the widest since 2012, when the euro area was starting to emerge from a debt crisis.

And the yield premium investors demand now to hold 10-year Italian bonds relative to Germany, the euro zone’s benchmark debt pushed out to 182 bps — the widest since last June.

Patrick O’Donnell, investment manager at Aberdeen Asset Management in London said the uncertainty over the new government’s policymakers and policies was driving the spread higher over “safe” German Bunds.

“There is focus on the individual names of the government and that may be a positive if they are seen as mainstream, but at the end of the day we are going to get a programme that is very confrontational with Brussels and mean more BTPs (Italian bond) issuance,” he said.

Ratings agency Fitch warned that policies being mooted by the incoming government would increase fiscal risks in the country which it currently rates at “BBB” with a stable outlook, just two notches into investment grade.

German yields are flat on the day at 0.52 percent.

However, the Italy-Germany spread remains below the 200-plus bps levels seen early last year when euro zone break-up fears gripped markets before French presidential elections.

Spanish and Portuguese bond markets felt some pressure from Italy’s selloff — Portugal’s 10-year yield jumped 10 bps, its biggest one-day rise since January while Spanish yields rose around 8 bps. However, yields across much of the euro zone were lower on the day.

One reason is that Italy is far from being in crisis, with its economy growing, interest rates low and the European Central Bank’s asset purchase programme a potent backstop for its and other bond markets in the euro zone.

Aberdeen’s O’Donnell reckons this will cushion Italy from further selling, although the situation would have to get “materially worse” before the ECB considered any action.

ECB Governing Council member Ewald Nowotny acknowledged that potential policy changes in Italy were creating a lot of nervousness, but said it was necessary to wait to see what is actually put into practice.

CDS, STOCKS JITTERY

The risks however fuelled another jump in Italian five-year credit default swaps (CDS) which rose 12 bps to a seven-month high of 136 bps, according to IHS Markit.

The CDS was below 90 bps at the end of April.

Italy’s political situation is also giving investors another reason to sell the euro against a resurgent U.S. dollar.

The single currency fell to a six-month low of $1.17170 against a broadly sturdy dollar.

It also fell for a sixth straight day against the Swiss franc, taking cumulative losses to more than 2.2 percent — its biggest six-day loss since June 2016.

Speculative long euro positions, essentially a bet that single currency will rise, have been cut back and are now flat for the year.

Italian stocks sold off too, falling as much as 2.1 percent , further weighed down by a number of stocks going ex dividend.

Shares in banks fell more than 3 percent, with some names down 6 percent or more thanks to their large holdings of Italian debt estimated at 8.5 percent of their total assets as of February, according to their financial statements.

“The problem here is that BTPs are falling away a treat. The market is afraid that ministries, starting from the economy, will go people not up to the job,” said Carlo Franchini, head of institutional clients at Banca Ifigest in Milan.

Italian stock futures faded by the end of the session but had risen as much as one percent earlier when bargain hunters stepped in following last week’s falls.

Nick Gartside, chief investment officer at JP Morgan Asset Management, sees bonds also offering an opportunity.

“We have seen a big readjustment in spreads in short order, and we now see that as an opportunity in terms of the bond markets,” he said.

“Italy has a bit of room to extend the budget deficit and globally governments are doing that. Maybe if we get some more detail on the government posts and spending plans we could see stability in the spread.”

Reporting by Dhara Ranasinghe and Saikat Chatterjee in London, Danilo Masoni in Milan; Editing by Sujata Rao and Catherine Evans

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