By Dhara Ranasinghe
LONDON (Reuters) - A deepening political and constitutional crisis in Italy, the euro zone's third biggest economy, fuelled a sharp rise in the country's short-term borrowing costs on Tuesday and renewed selling in the euro and stocks.
Italy's president set the country on a path to fresh elections on Monday, appointing a former International Monetary Fund official as interim prime minister with the task of planning for snap polls and passing the next budget
Concerns that fresh elections could deliver an even stronger mandate for Italy's anti-establishment parties rattled investors, sending two-year Italian bond yields up around 84 basis points, as London markets reopened after a holiday on Monday.
The 5-Star Movement and far-right League have dropped plans to take power and have switched to campaign mode. 5-Star have also called for street protests against President Sergio Mattarella's rejection of their nominee for economy minister, 81-year-old Paolo Savona, who has argued for Italy to quit the euro zone.
"The spectacular rise of 2-year yields in Italy this morning reflects break-up or redenomination fears," said ING senior fixed income strategist Martin van Vliet. "Markets are increasingly concerned about Italy and we are now waiting to see if the European Central Bank says something to calm markets down."
The ECB's bond buying programme has provided a powerful backstop to euro zone government debt, although moves in Italian markets in recent days suggest that this buffer may have lost its punch.
Italy's 2-year yield was last up 91 bps at 1.81 percent <IT2YT=RR>, having touched its highest since late 2013.
As Italian 10-year bond yields jumped 20 bps to their highest level in almost four years at 2.88 percent <IT10YT=RR>, the gap over German Bund yields hit 264 bps - its widest since September 2013.
"It's all driven by (Italian BTP bond) futures, there are little volumes on the cash market. (The sell-off) is linked to worries that the upcoming general election will be a referendum on the euro," said a Milan-based trader.
Another trader said the move was driven by growing worries the League could strengthen its hand in any fresh election.
The cost of insuring exposure to Italian risk in the five-year credit default swaps market rose to a 4-1/2 year high of 225 basis points, a jump of 49 basis points on the day, data from IHS Markit showed.
Italy's main stock index <.FTMIB> fell to a 9-month low as investors took flight on fears a new election could become a referendum on euro membership.
Shares in Italian banks <.FTIT8300> slumped another 2.4 percent, bruised by the sell-off in sovereign bonds. Italian banks are major holders of the country's sovereign debt.
The euro <EUR=EBS> dropped below the $1.16 line for the first time in 6-1/2 months on Tuesday, down 0.3 percent on the day. Against the franc, it fell by a similar margin at 1.1528 francs per euro.
Spain's bond-yield spread with Germany, pushed out also by political worries in Madrid, was at its widest in seven months at 122 bps <ES10YT=RR>.
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 threatened his six-year rule.
ADVERTISEMENTThe political uncertainty in Italy and Spain boosted demand for safe-haven German bonds, with both short and long-dated bond yields in Europe's biggest economy falling to fresh multi-month lows <DE2YT=RR>.
Germany's 10-year bond yield dropped briefly to a fresh 2018 low below 0.30 percent and was last down 3 bps at 0.31 percent. Its two-year bond yield tumbled to minus 0.78 percent <DE2YT=RR>, its lowest level in more than a year
"Taking any position in Italian debt, long or short is dangerous right now," said David Roberts, Head of Global Fixed Income, Liontrust Asset Management.
ADVERTISEMENT(Reporting by Dhara Ranasinghe, Helen Reid and Saikat Chaterjee in London and to Elvira Pollina and Elisa Anzolin in Milan; editing by David Stamp)
