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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 of 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.
After a sell-off in Italian bonds and stocks on Tuesday, investors on tenterhooks in early trade on Wednesday. In the grey market, the yield on the new 10-year bond maturing May 2023 was trading at 4.97 percent after briefly topping 5 percent, up from 4.90 percent late on Tuesday.
If confirmed at the auction, that level would be the highest since September 2012. At the end-January sale, Rome paid 4.17 percent to sell 10-year paper.
"The market is very nervous, every piece of news could trigger a violent reaction," said a Milan trader.
The premium investors demand to hold 10-year Italian bonds over equivalent German Bunds stood at 345 basis points after earlier touching a peak at 350 basis points.
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.
"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.
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.