Outgoing prime minister Giuseppe Conte has accepted a fresh mandate offered by Italy's president Sergio Mattarella to try to form a new coalition of the anti-establishment Five Star Movement and the centre-left Democratic Party (PD).
Conte said he would lead a government that "would concentrate on the needs of citizens and would make us proud of being Italian," the FT reported.
He had been leading Italy's government for the past 14 months until he resigned last week following Matteo Salvini's call for fresh elections.
We believe this is the best possible outcome for Italy as PD is more fiscally conservative than the 5-Star Movement and is also keen on reforming the number of seats in Parliament. This is also positive for Italian bonds especially given that we expect the ECB to reintroduce QE in the near future."
But the attempt of the far-right League party's leader Salvini to call for a vote seems to have failed as the Five Star and the PD announced on Wednesday their aim to form a government under the leadership of Conte following weeks of tense talks.
"We must immediately get to work and draw up a budget to avert the VAT hike, protects savers and offers solid prospects for economic growth and social development," he said. VAT in Italy will rise from January 2020 unless the government can find €23bn elsewhere.
Markets have received a boost following Conte's announcement. The outgoing prime minister has accepted Mattarella's mandate in a bid to avert new elections while sideline Salvini, which could bring to an end three weeks of political turmoil in the country.
Italy's 10-year bond yield fell to a record low below 1% on Wednesday on growing hopes that a new government will soon be formed.
David Zahn, head of European Fixed Income, Franklin Templeton, said: "We believe this is the best possible outcome for Italy as PD is more fiscally conservative than the 5-Star Movement and is also keen on reforming the number of seats in Parliament. This is also positive for Italian bonds especially given that we expect the ECB to reintroduce QE in the near future.
"However, we expect there will be more noise and Anti-European talk from Salvini/League that could create some volatility in the bond markets, providing a good entry point for investors. In our view, a more centre party in government helps mitigate some of these more extremist views.
"Overall, we believe the new coalition government should be supportive for Italian debt going forward and we remain long Italy."
Matteo Ramenghi, chief investment officer of UBS WM Italy , said: "The M5S-PD government is not a done deal. Substantial obstacles still need to be overcome in areas such as assigning the key roles and, assuming the president will give a mandate to Giuseppe Conte, passing a confidence vote.
"Interestingly, we think it will be less challenging to agree on an agenda between M5S and PD because the priorities both political forces have set out seem broadly consistent in many areas, ranging from fiscal policy to Italy's relationship with the EU to a focus on a green economy.
"We expect the market reaction to an M5S-PD government formation to be overall supportive in consideration of the likely fiscal discipline and pro-EU stance.
"From a macroeconomic perspective, the political uncertainty over the last few months has heavily affected sentiment and negatively impacted companies' investment plans. Better political stability may lead to a capital expenditure recovery, albeit in the context of decelerating growth globally."