UPDATE 2-Italy stocks, bonds dive as vote reignites euro fears
* Italian bonds, shares seen falling on political gridlock
* Vote for upper house deadlocked
* "Worst possible outcome for markets" -analyst
MILAN, Feb 26 (Reuters) - Italian stocks and government bonds fell sharply on Tuesday, after inconclusive elections left Italy facing political deadlock and rekindled fears of a new euro zone debt crisis.
Shares in Italy's main index fell 5 percent in early trade, dragged down by losses of 10 percent and more on the biggest banks, major lenders to the state.
The closely watched yield spread between Italian and German 10-year bonds widened to a peak not seen in two and a half months of 346 basis points in early trading.
Italy's messy vote, which gave a majority to the centre-left in the lower house but no clear control of the Senate to any party, sent shockwaves across the main euro zone markets, dragging Paris and Frankfurt down and pulling the euro to a seven-week low against the dollar.
Traders and analysts said the divided parliament and the massive surge of what they see as an anti-austerity vote embodied by the meteoric rise of comedian Beppe Grillo's 5-Star Movement and by the success of Silvio Berlusconi's conservative bloc was "the worst possible outcome" for markets.
"We don't know who our next government will be led by. There's a total lack of political direction. Before waiting to see how the scenario develops, investors are selling," said an equity trader in Milan.
Yet, suggestions by Berlusconi that he may be open to do a deal with the centre-left Democratic Party of Pierluigi Bersani helped reduced some of the initial losses.
"Italy cannot be left ungoverned. We have to reflect," the media tycoon and former prime minister said.
Berlusconi, who staged an impressive comeback by attacking the reform programme of technocrat premier Mario Monti, ruled out a deal with the internationally respected economist.
The Italian confusion also sparked a sell-off of vulnerable Spanish and Portuguese bonds.
Spanish Foreign Minister Jose Manuel Garcia-Margallo said he was extremely worried about the Italian election result.
"This is a jump to nowhere that does not bode well either for Italy or for Europe," Garcia-Margallo told journalists on the sidelines of a conference in Madrid.
Rome will face a key market test of its creditworthiness when it offers 8.75 billion euros of 6-month BOTs at 1000 GMT.
Strategists expect Italy to be forced to pay a higher premium to sell its short-term debt as indicated by a rise in six-month yields on the secondary market ahead of the auction.
"The bottom line is that political instability is likely to prevail in the near term and slow the implementation of much needed structural reforms unless a grand coalition among the centre left's Democratic Party, Berlusconi and the centrists is formed," said Barclays economist Fabio Fois.