Euro drops most in 15 month as Italy worries grow

A machine counts and sorts out euro notes at the Belgian Central Bank in Brussels October 26, 2011.

NEW YORK (Reuters) - The euro fell the most in 15 months against the U.S. dollar on Wednesday, and fears Italy could be the next euro zone country to seek a financial bailout suggested more losses to come.

Italian government bond yields soared above 7 percent after clearing house LCH.Clearnet SA raised the level of collateral needed for those holding the country's debt. Analysts view a 7-percent yield as unsustainable, and both Portugal and Ireland were bailed out after their bond yields exceeded that level.

Investors feared prolonged political instability in Italy could cause delays in economic reforms, while the euro zone and international lenders would struggle to assemble a bailout large enough for the country, the euro zone's third largest economy. The euro zone has no plans for a financial rescue of Italy, officials said.

"Overall, you're not likely to see any letup in the negative sentiment and selling pressure," said Samarjit Shankar, managing director of global FX strategy at BNY Mellon in Boston. "If there's no quick resolution in the next few days, you could see low $1.30s on euro/dollar."

The euro last fell 2.1 percent to $1.3547. It had earlier hit a session trough of $1.3522 on Reuters data, more than 3 cents off an intraday peak of $1.3858. At current levels, it was on pace for the biggest one-day percentage drop since mid-August, 2010.

The euro zone common currency rallied Tuesday after Italian Prime Minister Silvio Berlusconi said he will resign after the country's new budget law is approved, raising hopes a new leader will act more aggressively to tackle debt problems.

"The euro has sort of defied gravity for the last couple of days, and it's clearly looking like it has been having a Wile E. Coyote moment, sort of running off the end of the cliff without realizing that there's nothing underneath," said Ray Attrill, head of FX strategy for North America at BNP Paribas in New York.

IMPLIED VOL

One-month implied volatility in the euro/dollar, which gauges market expectations of the pair's currency moves in either direction, jumped above 16 percent from 14.45 percent the previous session.

Soaring bond yields forced the European Central Bank to buy Italian debt aggressively on Wednesday, according to traders.

Brown Brothers Harriman currency strategist Mark McCormick said the ECB may be forced to increase those purchases or cut interest rates again next month.

Worries about Greece also lingered as a deal on forming a Greek national unity government collapsed. Athens will run out of money next month unless the new government agrees emergency funding with the European Union and International Monetary Fund.

German and French officials have discussed plans for a radical overhaul of the European Union that would involve establishing a more integrated and potentially smaller euro zone, EU sources say. The discussions also raised the possibility of one or more countries leaving the euro zone.

The euro fell 2 percent to 105.42 yen. It also dropped 0.6 percent to 1.2310 Swiss francs.

The dollar rose 0.2 percent to 77.81 yen and gained 1.6 percent to 0.9088 Swiss francs.

Fears about Italy's debt and steep losses in stocks lifted the safe-haven U.S. currency. The U.S. dollar index, which tracks the value of the greenback against a basket of currencies, rallied 1.7 percent, its biggest one-day advance since August, 2010.

(Additional reporting by Gertrude Chavez-Dreyfuss; Editing by Diane Craft)