UPDATE 2-Sell off grips southern European bond markets, Spain uncertainty weighs

A selloff in southern European bond markets gathered pace on Monday, pushing yields higher, with an inconclusive election in Spain adding to uncertainty in its bond market. Government bond markets across the single-currency bloc have been hurt in recent weeks by optimism over a U.S.-China trade deal and signs of stabilization in economic data.

But Italy's bond market, in particular, and to a lesser extent Spanish and Portuguese ones have borne the brunt of selling in recent sessions. Analysts put this down to a number of factors such as a growing sense that further European Central Bank stimulus is unlikely and profit-taking on stellar gains in peripheral bond markets before year-end -- Italian and Spanish 10-year bond yields are down 140 and 100 basis points respectively this year.

They said a Financial Times article, reporting that new ECB chief Christine Lagarde is to face calls for an overhaul of how the ECB decides monetary policy highlights that the bar to further policy action is high. That is seen as negative for peripheral bond markets - which have been strong beneficiaries of ECB asset purchases.

"The FT article adds to this notion that the ECB is reaching the limits of what it can do, rate cut expectations have faded and that helps explain the weakness in peripheral bonds," said Rainer Guntermann, a rates strategist at Commerzbank. While yields on higher-rated bonds such as German and Dutch ones were steady, 10-year yields across southern Europe rose.

Italy's 10-year bond yield was 7 bps higher on the day at 1.34%, while its gap over Bund yields was at its widest in over two months at around 161 bps. It has jumped 30 bps this month alone, while French and German peers are up around 12 bps each.

In Spain, 10-year bond yields rose 2 bps to 0.41%, pushing the gap with its German peer to its highest level since mid-October at around 67 bps. Spain's acting prime minister, Socialist leader Pedro Sanchez, faced the prospect of hard bargaining to form a government on Monday after his gamble on holding the country's second election this year resulted in no clear winner but a surge for the far right.

Political uncertainty has so far had a limited impact on Spanish bonds, which have been supported by a relatively firm economy although analysts warned of weakness ahead. "The path to a coalition government is still unclear with this result," said Peter Chatwell, head of rates strategy at Mizuho in London.

"We expect our trades geared towards Spanish weakness to perform, given the lack of election uncertainty premium that was priced into Spanish bonds." Federico Santi, senior analyst for Europe at Eurasia Group, said that a third consecutive election has now become more likely although it is widely seen as a last resort.