Italian shares and government bonds fell March 26 after a weekend deal increased the chances of a government formed by the radical anti-establishment Five Star Movement and the eurosceptic right-wing Northern League.

Luigi di Maio, head of the Five Star Movement, now the largest single party in Italy's parliament, and Matteo Salvini, head of the League, have forged a personal rapport since elections on March 4 and said March 24 that they had negotiated the appointment of the heads of the two chambers of parliament. Center-left Prime Minister Paolo Gentiloni tendered his resignation on the same day but remains in position as caretaker.

Milan's FTSE MIB share index fell 1.2%, more than any other major European bourse. UniCredit SpA and Intesa Sanpaolo SpA, the two largest banks in the country, saw their share prices drop by 2.4% and 1%, respectively. The yield on benchmark 10-year Italian sovereign paper rose by four basis points to 1.912%, as German Bund yields held steady at 0.524%.

"Although both leaders pretend the deal has no bearing on the government talks, the test was happily passed, with both leaders congratulating each other for the good working relationship," wrote Lorenzo Codogno, an Italian academic and ex-Treasury official, in a research note March 26. "What was defined as a Frankenstein alliance now looks a real possibility," he added, in reference to a possible coalition between the two parties, which would come in defiance of their own policies and electoral promises. The academic calculated a 35% chance of a Northern League-Five Star government.

Although a Five Star-League "Armageddon" government may not trigger any immediate market crisis, Codogno said investors should watch out for any steps toward defying the EU's 3% fiscal deficit limit, legal unwinding of hard-won labor market and pension reforms, as well as "any sign of a return to anti-euro rhetoric, including that for a parallel currency."

"If all three or just one happens, it would be a sufficient enough reason for financial markets to topple. It would be a significant and painful encounter for the new administration. If, on the other hand, any new government sends reassuring signals on these three counts, even a League-5SM would probably not overly upset financial markets, in my view," said Codogno, forecasting new elections in October 2018 or in May 2019 due to the instability that would likely ensue.

"The possibility of a 5SM-Center right alliance has become the obvious starting option for the government formation guessing game," said analysts from Dutch bank ING, referring to the shorthand name for the Five Star Movement and the broader political group of which the Northern League is the largest party. "Given the rather overt intolerance to current fiscal rules shown by both the League and the 5SM during the campaign, passing the 'European' test might not be easy," they added.

Consultations on the new government are expected to start April 3.