LONDON (Reuters) - Investors are scrambling for protection against the risk that Italian elections next week could produce a political stalemate that will make fiscal reforms more difficult to implement.
Worries before the election on February 24-25, have already weighed on the euro and hit stocks and higher-yielding euro zone bonds with analysts predicting fresh selling pressure in the run-up to the closely fought vote.
Final polls before a pre-election black-out showed the centre-left party of Pier Luigi Bersani still on course to win, though it might need to forge a coalition with outgoing reformist premier Mario Monti.
Nevertheless, a strong surge by former Prime Minister Silvio Berlusconi has rattled some investors who worry his centre-right coalition could block the country's much needed reforms.
With debt of around 2 trillion euros (1.74 trillion pounds) and the economy barely growing, analysts say Italy needs structural reforms and the election could determine the pace at which they are implemented.
"The best thing (is) to play it cautious ahead of the vote," said David Thebault, head of quantitative sales trading at Global Equities.
He recommended buying put spreads on the Euro STOXX 50 index .STOXX, which he said were cheap, with a one-month horizon.
To play a put or call spread, an investor buys put options -- bets on the market falling -- or calls at a specific strike price while also selling the same number of puts or calls at a lower strike price. In this way, the investor captures market movements without the higher cost of buying and selling stocks.
Italy's borrowing costs are still around their cheapest in over two years while the country's stock markets is among the best performing in developed Europe -- up 33 percent since the ECB's pledge in July to do whatever it takes to save the euro bolstered confidence in Italy and other indebted euro zone countries.
Over the last three weeks, however, the prospect of political instability has seen the blue-chip FTSE MIB index .FTMIB fall around 6.5 percent, while bond yields rebounded.
Italian 10-year benchmarks are yielding 4.50 percent, up 40 basis points from January's lows with some analysts saying they could rise to September peaks around 5.5 percent if the election result is inconclusive.
This could lead to some volatility in debt from Portugal and Spain (where a corruption scandal has engulfed Prime Minister Mariano Rajoy's party) as well but any sell-off in these markets was likely to be tempered by the European Central Bank's conditional promise to buy bonds of struggling issuers.
"The problem is if you go into this (political) limbo what you risk is that markets might try to push (Italian) BTPs wider knowing there will be nobody to take political responsibility ... That is not the case in Spain," said Citi head of global rates Alessandro Tentori.
He preferred shorter-dated Spanish bonds, which fall within the ECB's scheme aimed at debt with maturities up to three years, to Italy. He said the two-year premium of Spanish Bonos over BTPs could fall to 75 bps from the current 95 bps in the coming week.
Other investors, like Robin Marshall, a fixed income director at Smith and Williamson Securities, preferred to stay out of Italian and Spanish bonds altogether for now.
"We've missed the rally in Spain and Italy and there's no prize for being the first back in...you could be catching a falling knife," said Marshall, who helps manage about $18 billion. Yields would have to 6-6.5 percent to make him reconsider.
"Those levels would be interesting but it depends on what happens. You need to see the context, if the same people are going to be in the government and how the economy is doing."
Any post-election instability would lead to a selloff in the euro, which has been under pressure this week after data showed the euro zone feel deeper than expected into recession in the last quarter of 2012, fuelling talk of an interest rate cut.
Howard Jones, an adviser at money managers RMG Wealth Management, said that if Berlusconi ended up with significant influence on policymaking that would be negative for the euro.
"If there is no clear verdict, the politics in Italy along with what is happening is Spain are negatives that are stacking up against the euro. These political developments can drive the euro down towards $1.25-1.28," he said. The euro was last at $1.3350, having topped 1.37 on February 1.
Though some analysts, such as those at JPMorgan said political risks were overdone and the Italian share market remained among the cheapest among developed European bourses, few were brave enough to buy Italian stocks outright for now.
Thebault at Global Equities said he would also be buying "call spreads with a longer-term view, say six months, because once we get more visibility in the next few months, the Italian and the European market will rally again".
(Graphics by Vincent Flasseur, additional reporting by Anirban Nag, Simon Jessop and Marius Zaharia, editing by Nigel Stephenson)