* Italian premium over Germany and Spain at multi-year highs
* Election jitters hits market, early gains wiped out
* Italian stocks tumble, banking index down 3 pct on day
* Safe haven German bond yields at lowest in five-months
* Euro turns negative on day, having been up 0.6 pct (Writes through)
By Abhinav Ramnarayan
LONDON, May 28 (Reuters) - Italian bonds and stocks sold off sharply on Monday and safe haven German debt rallied on fears of possible fresh elections and as investors took advantage of an initial rally to sell Italian assets, analysts said.
Jitters over a potential snap election in Spain added to worries over Southern European markets.
Italian assets briefly gained in early trade after President Sergio Matarella rejected a eurosceptic candidate for economy minister.
But the relief rally proved short-lived, with investors concerned over the risk that a fresh election could deliver an even stronger mandate for Italy’s anti-establishment parties.
This pushed Italian bond yield spreads over peers to their highest levels in years, and Italian stocks dropped sharply in value.
“I suspect the market initially interpreted it as good news, but now they are considering what will happen in terms of an early election and with populists maybe gaining an even bigger share,” said DZ Bank analyst Andy Cossor.
“And for some investors it’s just the case of offloading the positions given the uncertainty.”
Italy’s anti-establishment 5-Star Movement is considering campaigning together with the far-right League if the country goes back to the polls, a 5-star source said.
Italian 10-year government bond yields, which move inversely to price, were up a hefty 22 bps to a 3-1/2 year high of 2.67 percent, and set for its biggest daily rise since December 2015.
The premium investors demand to hold Italian 10-year debt over German was at its highest since December 2013 at 232 bps and the Italy/Spain 10-year bond yield spread was at its widest in over six years at 119 bps.
Safe have German government bond yields dropped to 0.35 percent, their lowest level in five months.
The Italian 2-year bond yield shot up 43 basis points — the biggest one-day move since July 2012 — to a three-year high of 0.89 percent, having been lower 14 bps at one point.
Italy’s main stock index fell 2.4 percent having surged at the open. Italian bank stocks were down 4.89 percent, their lowest in 13 months as investors looked to potential negative outcomes from likely fresh elections.
The euro also turned negative and was lower 0.3 percent, having been up as much as 0.6 percent earlier in the session.
Meanwhile, Spanish government bond yields hit fresh 2-1/2 month highs on Monday, hit by concerns over a potential snap election and also by Italian political uncertainty, which affected sentiment throughout Southern Europe.
Spanish Prime Minister Mariano Rajoy will face a vote of confidence in his leadership on Friday as corruption convictions handed down to dozens of people linked to his centre-right People’s Party (PP) threatened his six-year rule.
The yield on 10-year Spanish government debt briefly touched 1.537 percent, the highest since March 5, before settling at 1.52 percent; still up 6 basis points on the day.
“Political turmoil has put European government bond markets in crisis mode as snap election fears in Spain add to the uncertainty emanating from Italy,” ING analysts said in a note.
The premium investors demand to hold Spanish 10-year debt over the German equivalent was at its highest since the start of the year at 114 basis points.
Reporting by Abhinav Ramnarayan and Helen Reid Editing by Saikat Chatterjee and David Holmes