LONDON (Reuters) - Italian bonds, stocks and the euro rallied on Monday after President Sergio Mattarella rejected a eurosceptic candidate for economy minister, prompting the anti-establishment 5-Star and League parties to abandon plans to form a government.

FILE PHOTO: The Milan stock exchange building is seen in downtown Milan March 18, 2013. REUTERS/Alessandro Garofalo/File Photo

But analysts warned that the rally could prove short-lived with new elections now likely, adding more uncertainty to the political situation in the euro zone’s third largest economy.

Mattarella is expected to ask former International Monetary Fund official Carlo Cottarelli on Monday to head a stopgap government amidst political and constitutional turmoil. He will meet Cottarelli at 1130 am (0930 GMT) on Monday, an official said.

Mattarella’s refusal to accept Paolo Savona as economy minister, because the 81-year-old had threatened to pull Italy out of the euro, boosted sentiment towards the currency.

“We are seeing a decent relief rally in European markets, starting with the euro overnight, with the risk of an anti-euro finance minister in Italy being averted,” said Commerzbank strategist Michael Leister, though he added it should be put in the context of Friday’s heavy sell off in Italian assets.

On Monday, the euro EUR=EBS rallied 0.6 percent to $1.1728 at one stage, pulling itself above 6-1/2 month lows. It strengthened 0.8 percent against the Swiss franc EURCHF=EBS , bouncing sharply from near 3-month lows.

Italian 10-year government bond yields dropped 10 basis points to 2.35 percent in early trade IT10YT=RR, coming off one-year highs, while two-year yields fell as much as 17 bps IT2YT=RR and were set for their biggest daily drop in three years, coming off 3-1/2 year highs hit on Friday.

The closely-watched premium of Italian 10-year bond yields over their German equivalent - considered one of lowest risk investments in the world - narrowed 12 bps from Friday's close at 193.7 bps DE10IT10=RR.

(For graphic on Italy/Germany yield spread tightens as eurosceptic minister blocked, click reut.rs/2LAJoMl)

The FTSE MIB .FTMIB climbed 1.4 percent as financials and utilities surged. Italy's banks index .FTIT8300 jumped 3.1 percent, set for its biggest gain since January. Unicredit, UBI Banca, Banco BPM and Intesa Sanpaolo rose 2.2 to 2.8 percent.

However, market participants warned that the rally could prove short-lived as the League, under Matteo Salvini, might improve its performance from the last, inconclusive elections in March that led to months of political wrangling.

“We go into new election and Salvini could emerge as a stronger figure at the end of that. It’s quite telling that Moody’s highlighted structural risks on Friday,” said Leister of Commerzbank.

Credit rating agency Moody’s said on Friday it may downgrade Italy’s sovereign debt, citing risks of weakened public finances and a row back on past reforms.

Gilles Guibout, portfolio manager at AXA IM in Paris, also said he believes a market rebound won’t last. “Now we need to understand what could be the outcome of a new vote but what’s clear is that Europe will be at the centre of the debate of the next campaign,” he said.

KOREA RELIEF

High-grade euro zone government bond yields rose partly on the news from Italy, but also due to the renewed possibility of improved relations between United States and North Korea.

President Donald Trump said on Sunday a U.S. team had arrived in North Korea to prepare for a proposed summit with North Korean leader Kim Jong Un, which Trump pulled out of last week before reconsidering.

The yield on Germany's 10-year government bonds DE10YT=RR was 4 basis points higher at 0.445 percent, coming off near five-month lows hit last week.