UPDATE 2-Italian bond yields jump as eurosceptic parties surge in election

* Eurosceptic parties a hurdle to stability, say analysts

* 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 (Adds quotes, graphic)

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, investors said.

"It's not a positive result because we have seen the ascent of parties that create some concern in terms of reforms, their views on the euro and their views on forming alliances. So this does not favour stability," said Maria Paola Toschi, global market strategist at JP Morgan Asset Management.

Franklin Templeton's David Zahn also pointed to the uncertainty, saying that he is not planning to change his underweight position until there is more clarity on the composition of the Italian government.

The yield on 10-year Italian government bonds jumped 10 basis points at the open to 2.14 percent, before settling at 2.09 percent; still up 5 bps on the day.

German 10-year government bond yields, meanwhile, touched 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.

The closely-watched spread between Italian and German yields was at 152 bps at one point, its highest since Feb 23.

Italy's five-year credit default swap rose to 106.75, its highest since January 15.

In stock markets, Italy's FTSE MIB blue-chip index was down 1 percent to a six-month low.

The euro currency fell 0.3 percent to the day's lows at $1.2280 in early trade 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 Dhara Ranasinghe and Giulio Piovaccari Graphic by Dhara Ranasinghe Editing by Peter Graff)