* Eurosceptic parties a hurdle to stability, say analysts
* Italian yields jump, safe haven German Bunds in demand
* Potential trade war between U.S., Europe adds to jitters
* Euro zone periphery bond yields tmsnrt.rs/2ii2Bqr (Adds quote, updates prices)
By Abhinav Ramnarayan
LONDON, March 5 (Reuters) - Investors dumped Italian government bonds on Monday and rushed to buy high-grade equivalents such as Bunds after a surge in support for anti-establishment parties in the country's election.
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, led by the 5-Star Movement, 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. Blackrock, the world's largest asset manager, said the election outcome could lead to pressure on Italian and other southern euro zone bonds.
Other major bond investors, such as Franklin Templeton's David Zahn, said they were waiting for clarity on the composition of the Italian government before reassessing their positions. Allianz Global Investors' CIOs Mauro Vittorangeli, told Reuters that he was "slightly underweight" on Italy, but remained upbeat. "The real message here is that the Italian economy is getting better, and when the market becomes aware of what the political situation is, they should continue to buy (Italian) BTPs," he said.
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 nearly 6 bps on the day.
German 10-year government bond yields, meanwhile, touched a one-month low of 0.596 percent as investors flocked to safe haven assets. They had risen slightly to 0.62 percent by late trades.
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 Jan. 15.
In stock markets, Italy's FTSE MIB blue-chip index was down nearly one and half percent to a six-month low.
The euro fell to as low as $1.2267 in early trade as the uncertainty of the Italian result cancelled out potential gains from German progress towards a coalition government. It had recovered slightly to $1.2321 by the end of the European session.
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, Fanny Potkin and Giulio Piovaccari Graphic by Dhara Ranasinghe Editing by Peter Graff and Susan Fenton