(Financial Times) -- Spanish and Italian bond and stock markets tumbled on Monday, bringing a months-long rally to an abrupt halt as investors pulled back amid a political storm in Madrid and as Silvio Berlusconi staged an electoral fightback in Italy.
Yields on Spanish sovereign debt suffered their biggest one-day percentage jump since September as the row over slush fund allegations engulfing Mariano Rajoy, Spanish prime minister, and his party rattled investors.
Mr Rajoy over the weekend denied allegations first made in El País that the prime minister's centre-right Popular Party operated a slush fund from which it paid money to senior party leaders, including Mr Rajoy himself.
But with Spain's opposition party calling on Mr Rajoy to resign as prime minister over the allegations, the country's benchmark 10-year bonds on Monday rose 23 basis points to 5.44 per cent. Yields move inversely to prices.
The scandal in Spain dominated a joint news briefing in Berlin with Mr Rajoy and his German counterpart, Angela Merkel. The Spanish leader insisted once again that the slush fund allegations were false.
Mr Rajoy also sought to dispel fears that his government would be weakened by the scandal -- and may find it harder to push ahead with economic reforms and austerity measures.
"I have the same desire, hope, strength and courage than when I arrived," he declared. Ms Merkel said the Spanish government had the "full trust" of Berlin in its effort to end the five-year economic crisis.
The unease over Spain rippled across the eurozone, however, with benchmark German Bund yields falling as investors sought havens.
Yields on Italian 10-year bonds rose 14bp to 4.47 per cent as nervousness grew over the outcome of Italy's general election. There was concern over opinion polls showing that Mr Berlusconi's centre-right coalition was narrowing the gap on the ruling centre-left and that the February 24-25 vote could lead to political instability.
Italy's FTSE MIB stock market tumbled 4.5 per cent as banking stocks came under pressure.
Shares in Italy's largest bank by assets, UniCredit, and Monte dei Paschi di Siena, Italy's third-largest bank which is at the centre of a widening scandal over the use of derivatives, both fell heavily.
Analysts said the re-emergence of Italy's former prime minister had raised concerns about the outcome of the national elections. Silvio Peruzzo of Nomura said "the risk of ungovernability remains very high" amid signs that no outright winner could emerge from the February vote.
"This is a recipe for instability and could be a catalyst for uncertainty in the market," he said.
Analysts said news from Spain and Italy had captured investors' attention and was feeding into underlying concerns over how long the markets rally would last and whether it was due a correction.
"It follows a period where peripherals have been performing well and there has been a level of caution about the extent to which that rally would last," said Jamie Searle, a fixed-income strategist at Citi.
"The market is looking at the political tension and asking whether this could be the catalyst for a change in direction."