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UPDATE 1-Italian bond yields jump as eurosceptic parties surge in election

* Anti-establishment parties a hurdle to forming government

* Italian yields jump, safe haven German Bunds in demand

* Potential trade war between U.S. and Europe adds to jitters

* Euro zone periphery bond yields http://tmsnrt.rs/2ii2Bqr (Writes through)

LONDON, March 5 (Reuters) - Investors dumped Italy's government bonds on Monday and rushed to buy high-grade equivalents such as German Bunds after the weekend Italian election saw a surge in support for anti-establishment parties, led by the 5-Star Movement.

Italy faces a prolonged period of political instability after voters delivered a hung parliament in Sunday's election, spurning traditional parties and flocking to anti-establishment and far-right groups in record numbers.

The surge to parties sceptical of the EU could prove a setback to stable government and to wider European integration, analysts said.

"Forming a stable government coalition (in Italy) will be even more difficult than expected, and the corresponding uncertainties that arise from that is not the scenario that markets like," said Commerzbank strategist Michael Leister.

The yield on 10-year Italian government bonds jumped 10 basis points at the open to 2.14 percent. That in turn pushed up yields on other low-rated Southern European government bonds from Spain and Portugal.,

German government bond yields, meanwhile, dropped to a one-month low of 0.60 percent, as investors flocked to safe haven assets in what is described in the market as a "risk off" trade - buying better-rated assets and dumping riskier ones.

Italy's blue chip FTSE MIB index was seen opening down 1.2 pct after election, according to IG Markets.

The euro currency fell 0.3 percent to the day's lows at $1.2280 as the uncertainty of the Italian result cancelled out potential gains from German progress towards a coalition government.

Germany's Social Democrats (SPD) decisively backed another coalition with Chancellor Angela Merkel's conservatives on Sunday, clearing the way for a new government after months of political uncertainty.

"But the Italian result will probably halt some of the momentum because even though Europe is traditionally driven by the French-German axis, Italy is still hugely important," said Erik Norland, senior economist at CME Group.

"To have (Italy) not in favour of deeper integration, anti-immigrant and move to a different fiscal line as Germany will limit the upside to the euro in the coming days and weeks."

Bond investors have also been spooked by fears of a looming trade war after U.S. President Donald Trump unveiled plans for tariffs on steel and aluminium imports. That has triggered threats of retaliation from trading partners.

"In general it is a bad thing for the economy. The overall effect is likely to be yields turning to the downward and spreads widening, especially if it escalates," said DZ Bank strategist Daniel Lenz. (Additional reporting by Danilo Masoni and Saikat Chatterjee Editing by Peter Graff)