By Francesca Landini
MILAN, Feb 27 (Reuters) - Italy will pay the price for its latest political crisis with higher borrowing costs on Wednesday when it sells longer-dated bonds to investors worried about an inconclusive election.
The vote cast over the weekend gave none of the political parties a parliamentary majority, raising the risk of prolonged instability and a rekindling the euro zone crisis.
The results, notably the dramatic surge of the anti-establishment 5-Star Movement of comic Beppe Grillo, left the centre-left bloc with a majority in the lower house but without the numbers to control the upper chamber.
"Markets have been underpricing Italian political risk for months and are now struggling to come to terms with an extremely unstable and fluid political situation," said Nicholas Spiro, managing director of Spiro Sovereign Strategy.
The political stalemate could halt reforms needed to spur growth and help Italy cut its massive 2 trillion euro debt pile.
As stunned parties look for a way forward after the messy result, the treasury will seek to sell between 3 billion and 4 billion euros of a new 10-year bond and between 1.75 and 2.5 billion euros of five-year paper.
The sale comes in a challenging environment as the outcome of a six-month bill sale and a sell-off on secondary market showed on Tuesday.
"Italy's debt market is facing its most serious challenge since the announcement of the European Central Bank's bond-buying programme last summer," said Spiro.
On Tuesday Rome's six-month borrowing costs rose by 0.51 percent compared to a similar sale at the end of January and reached their highest level since October 2012, shortly after the ECB pledged to buy bonds of struggling euro zone countries.
After Tuesday's sell-off, the 10-year debt costs could rise towards 5 percent at Wednesday's sale, coming back to a level not seen since the end-September issue, analysts said.
"The auction will likely bring an increase of 65-75 basis points in the cost of funding compared with last month's sale," Chiara Cremonesi, strategist at UniCredit, wrote in a note.
At the end-January auction, Rome sold the five-year bond at 2.94 percent and the 10-year issue at 4.17 percent.
In the grey market, the new 10-year bond maturing May 2023 traded at around 4.90 percent late on Tuesday.
The 10-year bond yield spread between Italian BTP and German Bund was at 346 basis points compared to 283 bps at the official Italian market close on Monday.
"We have seen today what could happen if political instability continues...I believe markets will not give politicians any breathing space," said Valerio De Molli, managing director of consulting firm The European House-Ambrosetti.
The risk is that the political stalemate may reverse a cautious comeback of foreign investors into Italy's debt that started after by the ECB's bond-buying pledge.
"If political parties are not able to give in the short term a strong signal of change, foreign banks could reduce their activity in the country," Guido Rosa, head of the Italian association of foreign lenders, told Reuters.
The treasury had taken advantage of a benign environment at the beginning of this year to cover more than 20 percent of its total 2013 refunding needs.