By Lisa Jucca and Francesca Landini
MILAN (Reuters) - Investors are awaiting the outcome of an Italian election that could trigger a sell-off in stocks and bonds and renew concerns about the euro if the polls bring an unstable government.
Opinion polls have suggested the centre-left Democratic Party (PD) of Pierluigi Bersani could secure a narrow victory in the recession-hit country, the euro zone's No. 3 economy.
But the rise of anti-establishment comedian Beppe Grillo's 5-Star Movement and the impressive comeback of centre-right leader Silvio Berlusconi have cast doubt over Bersani's ability to govern even if he forms a coalition with the centrist party of outgoing technocrat Prime Minister Mario Monti.
Stock gains in Asia helped lift the future contract on Italy's benchmark 10-year BPT bond.
"Asian gains are providing support and some investors are already betting on a relief rally if the centre-left wins," a derivatives trader said.
"But it's too early to tell and we can expect nervousness to emerge at a debt sale later today."
After an initial dip, BTP futures were trading 13 ticks higher at 111.96. But a more significant market reaction will only be seen after 1400 GMT, when voting ends and the first exit polls will start trickle in.
The Italian stock market was expected to open higher on the back of stronger European index futures.
"The stock futures are positive but I don't expect anything significant on the Italian market until the exit polls come out," a Milan trader said.
Italian stocks, which had remained mostly stable in the last two weeks before the vote, lost ground on Thursday on concerns that the rise of Berlusconi and Grillo would make it more difficult for PD to secure a majority.
"If we don't have an indication of clear winner, there will be pressure on Italian bond yields," said Ishaq Siddiqi, market strategist with trading house ETX Capital who said markets were expecting a Bersani win.
"If this is confirmed, there should be a short-lived positive reaction and the euro should go up."
"But the next immediate question for the market will be how viable the winning coalition will be and whether it is able to continue with much-needed reforms."
A debt auction scheduled for 1000 GMT on Monday could give an early indication of whether nervousness is prevailing. Italy is selling up to 4.25 billion euros in two-year zero-coupon bonds and inflation-linked BTPei bonds.
This, and the sale of six-month BOTs on Tuesday, should be a relatively safe play for the Italian Treasury ahead of a more challenging auction on Wednesday of 10-year bonds, which have been sold off by some foreign investors ahead of the elections.
The yield gap between 10-year Italian and German bonds stood at around 288 basis points on Friday, nearly half levels seen in late 2011, when Monti was called in to bring Italy back from the brink of a possible default that would have sunk the euro zone.
But Italian borrowing costs are still far too high, Italian bankers and businesses say.
"We need political stability and lower bond spreads," said UniCredit (MIL:UCG.MI - News) boss Federico Ghizzoni. "At 270, 280, 290 basis points the spread is unsustainable. Either it goes down or it creates serious problems for the Italian economy."
Analysts say 10-year bond yields, now at around 4.40 percent could drop to 4 percent in case of stable government, but would rise towards 4.75-4.90 if results are inconclusive.
The European Commission is forecasting Italy's economy to shrink by 1 percent in 2013, worst than previously expected and a painful reminder of the challenges awaiting Monti's successor.
"Foreign investors fear government instability in Italy or a fragmented government," said a senior Italian banker. "If this is the case, we could see a lot of market volatility."
(Additional reporting by Francesca Landini; Editing by Robin Pomeroy and Anna Willard)