By Dhara Ranasinghe and Abhinav Ramnarayan
LONDON (Reuters) - A deepening political crisis in Italy, the euro zone's third biggest economy, fueled a heavy selloff in Italian assets and the euro reminiscent of the euro zone debt crisis of 2010-2012.
Short-term Italian bond yields, which move inversely to price, were set for their biggest one-day jump since 1992 (IT2YT=RR), while Italian and wider euro zone banking stocks were set to suffer their worst day since August 2016 (FTIT8300).
Italy's president has set the country on a path to fresh elections by appointing a former International Monetary Fund official as interim prime minister, with the task of planning for snap polls and passing the next budget
The concern is that fresh elections could deliver an even stronger mandate for Italy's anti-establishment, eurosceptic politicians.
"The spectacular rise of 2-year yields in Italy this morning reflects break-up or redenomination fears," Martin van Vliet, ING Bank's senior fixed income strategist, said.
The 5-Star Movement and far-right League have dropped plans to take power and have switched to campaign mode. 5-Star have also called for street protests against President Sergio Mattarella's rejection of their nominee for economy minister, 81-year-old Paolo Savona, who has argued for Italy to quit the euro zone.
Italy's central bank chief warned on Tuesday that the state was "only ever a few short steps" from losing investors' trust.
The ECB's bond buying program has provided a powerful backstop to euro zone government debt, although moves in Italian markets suggest that this buffer may have lost its punch.
The closely-watched Italian-German 10-year bond yield spread, seen by many investors as an indicator for sentiment towards the eurozone, was at its widest level since June 2013. (IT10YT=RR) (DE10YT=RR).
The spread rose above 300 basis points, having almost tripled from end-April levels around 115 bps.
To view a graphic on Italian-German bond spread widest in half a decade, click: https://reut.rs/2LE8hXm
"With such an unclear Italian political situation, investors will continue to demand a significant uncertainty premium," said Isabelle Vic-Philippe, head of euro government bonds at Amundi, one of the Europe's largest investors.
Italy's 2-year yield spiked more than 150 bps to 2.73, while 10-year bond yields jumped 50 bps to their highest level in over four years at 3.38 percent (IT10YT=RR). Italian bond yields traded above their U.S. Treasury yields (US10YT=RR) for the first time in almost a year.
To view a graphic on Worst day for Italian 2-year bond yields since 1992, click: https://reut.rs/2J8e0qf
"It's all driven by (Italian BTP bond) futures, there are little volumes on the cash market. (The sell-off) is linked to worries that the upcoming general election will be a referendum on the euro," said a Milan-based trader.
The cost of insuring exposure to Italian risk in the five-year credit default swaps market rose to a 4-1/2 year high of 225 basis points, a jump of 49 basis points on the day, data from IHS Markit showed.
A rush to safe havens pushed Germany's 10-year bond yield to 0.19 percent (DE10YT=RR), its lowest in more than a year.
BANKS, RISKS
The selloff also engulfed broader Italian markets.
Italy's main stock index (FTMIB) fell to a 9-month low, down more than 3 percent on the day, with banks bearing the brunt of the losses due to their large sovereign debt holdings.
The bank index (FTIT8300) fell 5 percent to a fresh 13-month low and several stocks automatically suspended from trading for excessive losses.
It is the worst day for the Italian banks index since August 2016.
U.S. bank Morgan Stanley (NYSE:MS) recently said that Italian bond yields of above 2.4 percent could spark wider market and economic contagion by hitting the bottom line of banks that hold a sizable chunk of their assets in government debt.
Euro zone banks (SX7E) slumped 4.5 percent, set for their biggest one-day fall in 21 months.
The euro also fell sharply.
Against the dollar (EUR=EBS) it fell 0.8 percent to $1.1531, its weakest since early November. Against the Japanese yen (EURJPY=EBS), the single currency plunged to its lowest level since June 2017 at 125.10 yen.
Spain's bond-yield spread with Germany, pushed out also by political worries in Madrid, was at its widest in over a year at 143 bps (ES10YT=RR).
Spanish Prime Minister Mariano Rajoy will face a vote of confidence in his leadership on Friday as corruption convictions handed down to dozens of people linked to his centre-right People's Party threatened his six-year rule.
"Taking any position in Italian debt, long or short is dangerous right now," said David Roberts, Head of Global Fixed Income, Liontrust Asset Management.