Italian stocks and bond markets came under pressure on Monday, pushing the gap between Italian and German bond yields to its widest in almost two weeks, after Italy's anti-establishment 5-Star Movement raised the prospect of fresh elections.
5-Star leader Luigi Di Maio called for early elections in June, saying efforts to form a coalition after last month's inconclusive vote had got nowhere.
"Fresh elections would mean more uncertainty but we have to keep in mind that the market has remained calm so far," said DZ Bank rates strategist Daniel Lenz. "But this is a bit of a surprise and might explain why Italy is an underperformer today."
Italy's 10-year bond yield rose 6 basis points to around 1.80 percent, underperforming euro zone peers.
That pushed the gap over German Bund yields to around 125 bps, the widest in almost two weeks, and compared with around 117 bps on Friday.
Italy's stock market also took a knock, with the benchmark FTSE MIB index falling sharply. It was last down 0.4 percent and the sole European stock market trading in the red.
While Italian markets have proved relatively resilient in the wake of the inconclusive election in March, a fresh election could put investor sentiment to the test.
"Another election increases the probability of a League/5-Star government, which is the least market friendly outcome," said Rabobank's Lyn Graham-Taylor.
A centre-right alliance led by the anti-immigrant League won the most seats in last month's election and 5-Star emerged as the biggest single party. The centre-left Democratic Party (PD) came a distant third.
"It could be more of a bargaining tool to get the PD to the table," said Graham-Taylor, referring to 5-Star's using talk of a snap election in its coalition negotiations with the PD.
The sell off in Italy's bond market dragged Spanish and Portuguese bond yields 3-4 bps higher, while other bond yields in the single currency bloc were just a tad higher on the day.
Latest inflation data from Germany and Italy provided some support for regional bond markets.
Annual inflation in Germany, Europe's largest economy, slowed in April, data showed on Monday, pushing it further below the European Central Bank's target of just under 2 percent for the euro zone as a whole.
Data from Italy meanwhile showed annual inflation slowed to 0.6 percent in April from 0.9 percent in March.
"The German inflation data suggests another subdued inflation reading for the euro zone later in the week," Commerzbank rates strategist Rainer Guntermann said.
