By Lisa Jucca and Francesca Landini
MILAN (Reuters) - Hopes of an end to two months of political deadlock in Italy drove its financial markets higher on Monday after the re-election of 87-year-old Giorgio Napolitano suggested parties may be nearer a deal to form a government.
Napolitano, elected after days of squabbling thanks to a broad agreement between some of Italy's main political groups, had earlier made clear that he favored a new government over potentially destabilising new elections.
An inconclusive vote in February that split the parliament between three litigious parties left the euro zone's third-largest economy in limbo as it struggles to escape a deep recession.
Irate businessmen have been urging politicians to overcome divisions and take action to stem a wave of bankruptcies and spiraling unemployment.
"The markets are rallying because the new mandate to Napolitano averts the risk of snap elections and paves the way for a government backed by some of the major parties," said a Milan-based trader.
Italy's main stock market index, the FTSE MIB, was up 1.8 percent at 0706 GMT, outperforming gains in Paris, London and Frankfurt. Italian stocks accounted for more than half of the top gainers on the leading pan-European stock index, led by a 4 percent gain for insurer Generali.
Yields on Italy's benchmark 10-year BTP fell to just above 4 percent, a level not seen since late January.
Napolitano, the first president in Italy's history to be re-elected for a second term, will spell out his strategy later on Monday.
A source in the presidential palace told Reuters Napolitano could either hold a quick round of consultations starting on Tuesday or skip them altogether because he has already sounded out party leaders officially twice since the deadlock began.
Italian newspaper said Giuliano Amato, a former prime minister, was likely to be asked to form a new government.
"Given the strong support behind Napolitano's re-election, it is likely that a grand coalition government will find support too," Credit Suisse said in a note to clients.
An agreement of Italy's centre-right and centre-left blocs, with the addition of the small centrist contingent of Mario Monti, led to the choice of Napolitano on Saturday.
The anti-establishment 5-Star-Movement of former comedian Beppe Grillo had supported leftist academic Stefano Rodota and branded the choice of Napolitano as a desperate attempt by traditional parties to cling to power.
"A broad political coalition does not currently represent a huge risk factor for Italy: the country has a limited budget deficit and does not need a budgetary correction," said Alessandro Giansanti, a strategist with ING.
"Now the focus will be on pro-growth policies, rather than on austerity."
(Additional reporting by Giulio Piovaccari in Milan, editing by Patrick Graham)