UPDATE 3-Investors see bright side to Italy election
* Eyes on exit polls after voting ends at 1400 GMT
* Italy stocks up, bonds gain on expected centre-left victory
* Italy sells 4.07 bln euros of CTZs, BTPei at auction
MILAN, Feb 25 (Reuters) - Hopes of a victory for a pro-reform Italian government helped fuel a stock market rally and support government bonds on Monday in the final stages of voting in the general election.
Opinion polls before the vote and a low turnout on the first day of voting on Sunday prompted some traders to place bets on a victory for the centre-left Democratic Party (PD) of Pierluigi Bersani in coalition with outgoing Prime Minister Mario Monti.
Yet, markets fear a good showing of anti-establishment comedian Beppe Grillo's 5-Star Movement and of centre-right leader Silvio Berlusconi could damage the new government's ability to carry out reforms to help the eurozone's third-biggest economy exit recession.
"The expectation is for a centre-left government in alliance with Monti. This is supporting the market. But it remains to be seen if the new government will have a solid majority," said Carlo Gentili, Chief Executive Officer at asset manager Nextam Partners.
Voting continues until 1400 GMT on Monday, when the first exit polls will be published and trading volumes are expected to rise.
Heavy snow in several Italian cities and bad weather elsewhere kept some voters away from polling stations on Sunday, when turnout was 55 percent, down from 62.5 percent at a previous election.
This could hurt Berlusconi, whose voters tend to be older.
Italy's main stock market index, the FTSE MIB, was up 2.2 percent at 1120 GMT, partly on the back of buoyant European markets.
Meanwhile the 10-year bond yield spread between Italian government debt and its German equivalent tightened 10 basis points to 279, recovering from a dip just before a bond sale.
The Italian Treasury paid slightly higher borrowing costs to sell 4.07 billion euros - near the top of its targeted amount - of 2-year zero-coupon bonds and inflation-linked BTPs.
But at 1.68 percent, the yield paid was well below the 1.80 percent of the secondary market, traders said.
"Today the market is overall positive. But it is not fully pricing in the risk of a fragile government," said Alberto Gallo, an analyst with Royal Bank of Scotland. "Even if we get a PD-Monti coalition at the Senate, there are risks on whether reforms will continue."
Italy's complex electoral law could deliver a hung parliament if the winning coalition does not manage to secure enough seats in the Senate.
Analysts say Italy will face a bigger market test on Wednesday, when the electoral outcome will be clearer and the Treasury hopes to lure foreign investors at a more challenging 10-year government bond sale.
At 278 basis points, the yield gap between 10-year Italian and German bonds currently stands at 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 boss Federico Ghizzoni. "At 270, 280, 290 basis points the spread is unsustainable. Either it goes down or it creates serious problems for the Italian economy."
Analysts say 10-year bond yields, now around 4.3 percent, could drop to 4 percent in case of 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."