By Dhara Ranasinghe and Danilo Masoni
LONDON/MILAN (Reuters) - Italy's borrowing costs surged further 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 a prime minister to lead a coalition that plans billions of euros in tax cuts, additional 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 2-year bond yields jumped more than 10 basis points to 0.23 percent (IT10YT=RR), their highest since December 2016. Just a week ago, that yield was at minus 0.11 percent.
The gap between 10-year Italian and Spanish bond yields (ES10YT=RR) was at 81 basis points -- the widest since 2012, when the euro area was starting to emerge from a debt crisis.
As 10-year Italian debt yields hit 10-month highs at almost 2.30 percent, the gap over benchmark German Bund yields (DE10YT=RR) pushed out to 175 bps - the widest since October.
"If this is the government we're going it get, the Italian/German bond spread north of 180 bps is certainly a possibility," said Patrick O'Donnell, investment manager at Aberdeen Asset Management in London.
"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."
Graphic: Italian/Spanish yield gap at widest in 6 years - https://reut.rs/2LeUBSy
The cost of insuring exposure to Italian government bonds jumped to its highest in almost seven months at 128 bps, according to data from IHS Markit.
The Italian-German bond spread, however, remains below the 200-plus bps levels seen early last year when euro zone break-up fears gripped markets ahead of French presidential elections.
Also, most euro zone bond yields were down on the day, except in Spain and Portugal, where markets (PT10YT=RR) felt some pressure from the sell-off in Italy.
One reason is that the European Central Bank's bond-buying programme remains a potent backstop for the bloc's bond markets. 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 in practice.
But the rise in Italian risks is giving investors another reason to sell the euro against a resurgent U.S. dollar.
The single currency was down 0.3 percent at $1.17360 (EUR=). It fell for a sixth straight day against the Swiss franc (EURCHF=EBS), taking cumulative losses to more than 2.2 percent -- its biggest six-day loss since June 2016.
Since end-June last year, the euro had surged nearly 11 percent against the franc as concerns over a eurozone breakup receded swiftly after the French elections. The latest losses have cut its gains by a quarter since then.
Graphic - Euro: risk reversals and positions - https://reut.rs/2LiOAEf
OPPORTUNITY KNOCKS?
Italian stocks fell as much as 2.1 percent in early trade, further weighed down by a number of stocks going ex dividend, but trimmed the losses as the session went on. The market stood 0.2 percent lower by 1030 GMT (FTMIB).
Futures on the FTSE MIB (IFSc1) rose more than 1 percent as bargain hunters stepped in following a week of heavy losses. But some investors warned against rushing back.
"I would wait before considering the current phase of widening spreads and stock losses as an interesting buying opportunity," said Alessandro Balsotti, a portfolio manager at JCI Capital in Milan.
The FTSE MIB suffered its biggest one-week loss in more than two months on Friday, but it remains the best performer among major European stock markets and is up over 7 percent this year.
Nick Gartside, chief investment officer at JP Morgan Asset Management, added that the bond market also offered an opportunity after sharp selling of the past week.
"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."