LONDON: Italian government bond yield rose sharply on Tuesday, lifting southern European peers, as the possibility of an early Italian election increased with the country's largest anti-establishment parties polling strongly.
President Sergio Mattarella called on Monday for Italy's bickering parties to rally behind a "neutral government", but Italy's two largest parties, the far-right League and anti-establishment 5-Star Movement, rapidly came out against the proposal.
This raises the likelihood of an unprecedented immediate return to the polls, even as early as July.
"If we go to a new election, both M5S and the League are polling a bit higher than at the last election, so the worry for markets is that they are able to leave behind Forza and we get the government of non-traditional parties," said Rabobank strategist Lyn Graham-Taylor.
While 5-Star Movement and the League already had enough numbers to form a government, a fresh election may further strengthen their hand.
He said that investors are concerned that such a government may repeal pension reforms and potentially increase spending and tax cuts that could impact Italian public finances.
Italy has one of the highest debt-to-GDP ratios in Europe at 132 percent.
The closely watched Italy/Germany 10-year government bond yield spread hit its widest level in three weeks at 128 basis points, while Italian 10-year yields shot up 8 basis to its highest in six weeks.
Milan's FTSE MIB index was down over 2 percent, with Italian banks taking a strong hit and set for their worst day in two months.
Carlo Franchini, head of institutional clients at Italy's Banca Ifigest, said: "Markets were too optimistic about elections and were not expecting there could have been elections so early. That could put at risk the approval of the budget law and recent data has eroded confidence in the country's economic recovery."
Other Southern European government bond yields -- which move inversely to price -- were also higher by 4-5 bps.
Yields were also higher across the board as strong German data soothed concerns over the euro zone's largest economy and increased expectations the ECB will withdraw stimulus as planned.
German industrial output rose more than expected in March, data showed on Tuesday, suggesting that factories in Europe's largest economy ended the first quarter on a strong footing after two disappointing months.
Separate data published by the Federal Statistics Office showed exports rose 1.7 percent in March while imports fell 0.9 percent.
"After weak German industrial orders yesterday, today's numbers look much better and point towards decent GDP growth in Germany," said Commerzbank strategist Christoph Rieger.
Germany's 10-year bond yield rose 1 basis point to 0.54 percent.
A broad optimism across global markets may also explain the move higher in yields.
World markets were mostly in upbeat mood on Tuesday, with oil prices holding above the $75 a barrel level despite an expected US government decision on its involvement in the international Iran nuclear deal.
The euro fell below $1.19 for the first time this year on Monday and was at $1.1878 mid-morning.
Meanwhile, the US Federal Reserve Chairman Jerome Powell said on Tuesday the Fed's interest rate hikes may not pose as big a risk for global financial markets and emerging market economies as many have thought.
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