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Why Italy’s Stalemate Could Mean Chaos for Euro Zone

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Political deadlock will cause chaos in Italy and could provoke upheaval in the wider euro zone economy, as well as in the currency and equity markets, analysts told CNBC.

As no Italian party secured enough seats to win a majority in the country's upper house, the Senate, political deadlock is widely expected as parties struggle to form a cohesive coalition.

Perhaps a sign of things to come, the center-right leader Silvio Berlusconi ruled out forming an alliance with Mario Monti's centrist party, early on Tuesday, and said he needed "time to reflect" on forming an alliance with center-left coalition leader, Pier Luigi Bersani.

(Read More: Italy 'Hung, Drawn and Quartered' by Political Deadlock)

As markets digested the news, analysts told CNBC that investors should expect battles over austerity versus growth policies, and delays on much-needed economic reforms.

"It was the worst possible outcome, feared by market participants and European policy-makers alike," Tobias Blattner, European economist at Daiwa Capital markets, said on Tuesday.

"Italy is facing Greek-style political gridlock and possibly new elections."

Nicholas Spiro, managing director at Spiro Sovereign Strategy, agreed the election result was the worst possible one, as far as markets are concerned.

"Not only does it plunge Italy into a full-fledged political crisis, it deals a severe blow to the fiscal and structural reforms advocated by euro zone policymakers, and risks undermining the perceived credibility of the European Central Bank's OMT [Outright Monetary Transactions] program - the main pillar of support for euro zone peripheral assets over the last several months," said Spiro.

"The anti-establishment and anti-austerity backlash in Italy presents the biggest challenge to the euro zone's austerity-focused policies since the crisis erupted in 2010," he added.

Gerry Fowler, global head of equity and derivative strategy at BNP Paribas, said the results could damage attempts at closer cooperation in the euro zone.

(Read More: Berlusconi Rules Out Alliance; Yields Jump)

"While we're not sure now whether Italy will pursue austerity or growth, it is essentially a vote against European integration," Fowler said. "The Italian election is just the first step in what may be many months of catalysts that reignite concerns in the markets."

Some analysts fear the ECB could withdraw support for Italy, if reforms introduced by technocrat Prime Minister Mario Monti are delayed or withdrawn altogether. The OMT program, for instance, is conditional on reform measures being instigated.

JP Morgan Economist David Mackie said the ECB could find itself with limited firepower to help Italy, if fiscal and structural reforms are not continued.

"While the Italian election result may increase the need for a monetary response from the ECB, because it creates risks around the improving cyclical dynamic, it also makes it harder for the central bank to respond," Mackie said.

"The ECB has done a lot to support the region over the past three years, but throughout, it has argued there is a limit to what monetary policy can deliver. In the ECB's mind, its own response has to be complemented by developments at both the regional level (institution building) and at the national level (fiscal and structural adjustments)."

Yields Jump; Euro Falls

Investor fears told on the Italian bond market on Tuesday, with yields on 10-year sovereign notes reaching 4.87 percent, up from 4.45 percent at the European close on Monday. The spread between Italian bonds and safe-haven German bunds jumped 57 basis points to 336 basis points.

In addition, yields for Italian six-month notes jumped to their highest level since October 2012 at a 8.75 billion euro ($11.5 billion) auction on Tuesday. The average yield at the auction was 1.237 percent, up from 0.731 percent at the end of January.

With another auction due on Wednesday, Michael Gallagher, director of research at IDEAglobal, predicted Italy's borrowing costs would rise dramatically over the next couple of weeks.

"What we saw [today] is only the beginning, we can see another 50 basis points on Italian yields in the next coming weeks," he told CNBC Europe's "Squawk Box."

(Read More: Euro Rally: Was it Too Good to Be True?)

"Last July, we had a dramatic narrowing of their spreads and significant portfolio inflows into Italy. That money is now being destabilized.

"In the short-term we could have a negative development, but not necessarily a crisis. The critical thing in terms of Italian [debt] holdings are foreign holdings, which still remain very large. If those are destabilized then we could see the crisis increasing," he said.

Spanish stocks and bonds were negatively affected by the Italian election, as Spain is seen as vulnerable to contagion effects from Italy. However, Spiro said contagion from Italy was still "relatively contained", with the yield on 10-year Spanish Treasury bills up 9 basis points on Tuesday morning, compared with a 25 basis point rise in the Italian equivalent.

Meanwhile, the euro has fallen close to a seven-week low against the dollar, as investors seek safety in the greenback and the Japanese Yen.

Jane Foley, senior currency strategist at Rabobank, warned of further currency volatility in the next few weeks. "If you want to look at euro diversification, currencies such as the Swedish krona and the Norwegian krone perhaps have some support, but markets are going to be very sensitive to developments in the euro zone over the next few weeks."

However, Blattner said that short-term volatility aside, the rise in peripheral bond yields should be contained by the existence of the ECB's bond buying program, the OMT, which continues to provide a credible backstop for euro area countries.

"But the coming days will most certainly present the biggest test yet for the euro area's recovery from the crisis," he added.

Contact Europe: Economy

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