By Simon Jessop
LONDON (Reuters) - An inconclusive result in Italy's elections this weekend could prompt an even bigger sell-off in some markets than the return to power of scandal-mired Silvio Berlusconi, who led the country to the financial precipice in 2011.
Italian stocks, bonds and, to a lesser extent, the euro are all expected to rise if, as the latest polls suggest, the centre-left led by Pier Luigi Bersani wins a majority in the lower house and forms a stable pact in the Senate with outgoing centrist Prime Minister Mario Monti to head a reform-minded government.
But prices will fall if Italy, whose mountainous debts catapulted it to the forefront of the euro zone debt crisis under Berlusconi 15 months ago, emerges from the February 24-25 election with a hung parliament incapable of producing a stable administration, analysts say.
Italian debt and shares sold off sharply in recent weeks as Berlusconi made big gains in opinion polls. However, with his centre-right party lagging the centre-left by 4-5 points in the final polls before a pre-election blackout, markets have largely discounted the return to power of the media tycoon, who has been weakened by a string of sex and financial scandals.
"I am inclined to think the centre-left and centre will have control, but the marketplace as a whole is reasonably complacent about the risk we do not get that outcome," said UBS currency strategist Geoffrey Yu.
On the surface, markets appear calm just two days before voting. Italian stocks had regained half their 4 percent political risk-driven fall by Wednesday, and 10-year bond yields were off their recent highs.
Italy's blue-chip stock index, the FTSE MIB, having started 2013 strongly, is nursing losses for the year and lagging the pan-European Euro STOXX 50 and national indexes in France, Germany and Britain.
Antonin Jullier, global head of equity trading at Citi said a centre-left/Monti win could push shares higher.
"There is another 2 percent to grab in both the E-STOXX 50 and the FTSE-MIB if the result goes for Bersani-Monti," he said.
Aviva Investors reckon the gain under such a scenario could be as much as 5 percent, with the most market-neutral event being an outright Bersani win and the worst not a Berlusconi victory, which could prompt a 2 percent fall, but a hung parliament, which could see stocks fall 5 percent.
That fear has driven the cost of protection against a fall in the FTSE MIB to its most expensive since mid-September.
Italy's borrowing costs have fallen sharply since Monti formed his technocrat administration in November 2011. This is in large part due to last year's pledge by European Central Bank President Mario Draghi to do "whatever it takes" to save the euro and subsequent offer to buy the bonds of struggling euro zone countries that seek help - the so-called 'Draghi put'.
"Our perception is that the Draghi put is working, and this has changed the game to the benefit of peripherals," Commerzbank fixed income strategist Michael Leister said.
But there's a lot of paddling beneath the calm surface, with volumes in Italian bond futures at their highest four-week moving average since the contract was launched in 2009, a Reuters analysis shows. That means there are still plenty of investors bailing out of Italian bonds, while others, reassured by the ECB's back-stop, have been snapping them up.
A hung parliament would see yields, which move inversely to prices, jump, with a knock-on effect in the rest of the euro zone periphery, especially in Spain.
William de Vijlder, chief investment officer of BNP Paribas Investment Partners, said a stable reformist government could see 10-year yields fall towards 4 percent from levels around 4.9 percent, while stalemate could push them up towards 5.2 percent.
Louis Gargour, CIO of hedge fund firm LNG Capital, said a Berlusconi win could push Italian yields up 75-100 basis points.
Even that would leave yields below the unsustainable levels above 7 percent hit in late 2011.
Hedge funds were also betting on an expected rise in volatility in the euro's exchange rate against the dollar early next week, a chief options trader at a large European bank said.
"People are definitely heading into the election a bit more cautious. There was a lot more selling last week and a defensive stance," UBS's Yu said, adding a shaky coalition could see the euro fall to $1.30 from current levels around $1.32.
Dagmar Dvorak, director of currency and fixed income at Barings Asset Management, said the fund was underweight the euro before the election.
She also said the euro could fall to $1.30, but expected more reaction in bond markets as the single currency was supported by the ECB's policy stance.
"I don't expect a sharp move down in the euro. It is still supported by (the ECB's) balance sheet contraction versus expansion elsewhere."
(This story corrects surname in 17th paragraph to read Gargour)
(Additional reporting by Anirban Nag, Nia Williams, Emelia Sithole-Matarise, Toni Vorobyova, David Brett, Laurence Fletcher, Alistair Smout, Marius Zaharia, Sudip Kar Gupta, William James, Francesco Canepa and Annika Breidthardt; editing by Nigel Stephenson and Will Waterman)
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