By Lisa Jucca
MILAN (Reuters) - Investors are awaiting the outcome a wide open Italian election that could trigger a sell-off in stocks and bonds and renew concerns about the euro if the polls bring an unstable government.
Polling stations open for a second and final day on Monday and exit polls will be published soon after they close at 3 p.m. (1400 GMT).
Opinion polls have suggested the center-left Democratic Party (PD) of Pierluigi Bersani could secure a narrow victory in the recession-hit country, the euro zone's third-largest economy.
But the rise of anti-establishment comedian Beppe Grillo's 5-Star Movement and the impressive comeback of center-right leader Silvio Berlusconi have cast doubt over Bersani's ability to govern even if he forms a coalition with the centrist party of outgoing technocrat Prime Minister Mario Monti.
Exit polls soon after 1400 GMT could spark an initial market reaction although a clear political picture may emerge well after market close. Official results are expected by early Tuesday.
"If we don't have an indication of clear winner, there will be pressure on Italian bond yields," said Ishaq Siddiqi, market strategist with trading house ETX Capital who said markets were expecting a Bersani win.
"If this is confirmed, there should be a short-lived positive reaction and the euro should go up," he said.
"But next immediate question for the market will be how viable the winning coalition will be and whether it is able to continue with much-needed reforms."
Italian stocks, which had remained mostly stable in the last two weeks before the vote, lost ground on Thursday on concerns that the rise of Berlusconi and Grillo would make it more difficult for PD to secure a majority.
A debt auction scheduled for 1000 GMT on Monday could give an early indication of whether nervousness is prevailing. Italy is selling up to 4.25 billion euros in two-year zero-coupon bonds and inflation-linked BTPei bonds.
This, and the sale of six-month BOTs on Tuesday, should be a relatively safe play for the Italian Treasury ahead of a more challenging auction on Wednesday of 10-year bonds, which have been sold off by some foreign investors ahead of the elections.
"Most investors adjusted positions on Italy's debt two weeks ago and now they are sitting on the fence, waiting for the outcome of the election," said Luca Cazzulani at UniCredit.
"On Monday we could see volatility and the market may react to rumors on the polls ... The volatility may imply somewhat higher rates for Rome relative to most recent auctions, but I do not see difficulties on the demand."
The yield gap between 10-year Italian and German bonds stood at around 288 basis points on Friday, nearly half levels seen in late 2011, when Monti was called in to bring Italy back from the brink of a possible default that would have sunk the euro zone.
But Italian borrowing costs are still far too high, Italian bankers and businesses say.
"We need political stability and lower bond spreads," said UniCredit
Analysts say 10-year bond yields, now at around 4.40 percent could drop to 4 percent if the vote delivers a stable government, but would rise towards 4.75-4.90 if results are inconclusive.
The European Commission is forecasting Italy's economy to shrink by 1 percent in 2013, worst than previously expected and a painful reminder of the challenges awaiting Monti's successor.
"Foreign investors fear government instability in Italy or a fragmented government," said a senior Italian banker. "If this is the case, we could see a lot of market volatility."
Many Italians are already expecting a new general election should the new government turn out to be a very weak one.
"Our base case is for a weak Bersani-plus-Monti coalition potentially needing to be enlarged to take in other minor parties," said Antonio Guglielmi, an analyst with Mediobanca. "This would clearly not generate a strong government."
(Additional reporting by Francesca Landini; Editing by Robin Pomeroy)