UPDATE 3-Bank rescue hopes, dwindling threat of snap election boost Italian assets | Reuters

* Italian BTP yields set for biggest 1-day fall since Dec

* Italy stocks rally, outpacing peers

* Electoral law deal unravels; risk of snap election recedes

* Banks to contribute to state bailout of two lenders
(Updates with latest market moves, ECB decision)

By Dhara Ranasinghe and Danilo Masoni

LONDON/MILAN, June 8 Italy’ borrowing costs
tumbled and its shares rallied on Thursday as the euro zone’s
third-biggest economy appeared to take a step towards resolving
a crisis over two ailing lenders and a step back from snap
elections.

Reports Italian banks are considering contributing to a
state rescue of the country’s weakest lenders, Popolare di
Vicenza and Veneto Banca, brought some comfort to investors wary
of wider banking sector weakness, political uncertainty and a
tightening of monetary policy in the region.

Banking stocks in Italy rallied as much as 2.5 percent,
reversing initial falls on worries that a subsequent
intervention of the state in the troubled Veneto-based lenders
could reduce the value of their investment.

Momentum in bond and stock markets took hold after
a deal struck among Italy’s main political parties over a new
electoral law collapsed, easing concerns about early elections.

“BTPs rallied after the risk of a snap Italian election
receded on news that Italy’s big four political parties no
longer agree on a new electoral law,” said AFS analyst Arne
Petimezas in Amsterdam.

“As a reminder, Italy needs a new electoral law before new
elections can be held as the current law has been struck down by
the constitutional court. A warning though: this is Italy and
anything can happen.”

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The implications for early elections are far from clear.
Analysts said a meeting of the ruling Democratic Party later on
Thursday might bring more clarity.

Italy’s 10-year government bond yield slid 12 basis points
to 2.16 percent and was on track for its biggest
one-day slide since December.

It outperformed other European bond yields, which were
broadly lower after the European Central Bank cut its forecasts
for inflation and said policymakers had not discussed scaling
back its massive bond-buying programme.

Against this backdrop, the premium investors demand for
holding Italian government bonds over top-rated German peers
narrowed to 191 basis points – 12 bps tighter from
seven-week highs hit on Wednesday.

“Some of the political risk premium is now coming out –
investors were worried about the chance of a party less friendly
to the euro zone coming into power,” said Mizuho rates
strategist Antoine Bouvet.

In a note, analysts at Goldman Sachs said they would assign
around a 60 percent chance to an early ballot, with more clarity
on timing by mid-July.

BANK PLAN

State support for the two Veneto-based banks is not expected
to have a significant impact on Italy’s debt – which at over 130
percent of GDP is one of the highest in the euro zone. Analysts
estimate the two banks account for just 1.5 percentage points
each of overall Italian banking assets.

Still, progress towards a rescue was viewed as positive,
helping ease concern about a lack of progress in fixing a frail
banking sector.

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Rome won a preliminary green light from Brussels earlier
this month over its a proposed rescue of its fourth-largest
bank, Monte dei Paschi di Siena.

“I think it is positive as it reduces uncertainty and puts
an end to this story,” said Lorenzo Codogno, a visiting
professor at the London School of Economics and chief economist
at LC Macro Advisors.

“What is probably negative is that other banks have been
asked to assist, which clearly does not bode well for the
overall sector.”

The euro zone bank index was up 1 percent, while
Italy’s two biggest lenders, Intesa Sanpaolo UniCredit
, also rose, reversing earlier weakness but still
lagging gains in the broader banking sector. They were up 0.7
percent and 1.6 percent respectively.

Italy’s blue chip FTSE MIB index was up 1 percent
while Italian banks were 1.3 percent higher.
(Additional reporting by Stephen Jewkes in MILAN and Abhinav
Ramnarayan in LONDON; Editing by John Geddie and Andrew Roche)

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