FOREX-Euro recovers early losses, but reignited euro zone fears remain
* Euro rises to session high of $1.3119 as buyers emerge on dips
* But gains limited as Italy political gridlock weigh
* Euro rise capped at $1.3123, its 100-day moving average
* Bernanke's testimony at 1500 GMT
By Anooja Debnath
LONDON, Feb 26 (Reuters) - The euro recovered against the dollar on Tuesday as investors chose to buy back the single currency after it plummeted to a seven-week low earlier on fears of a political deadlock in Italy could cause wider problems.
Gains in the euro may, however, prove short-lived, according to some strategists, as the inconclusive election in Italy threatens to hinder economic reforms there and trigger a renewed euro zone crisis.
A fragmented parliament in Italy, the euro zone's third largest economy, could reignite fears about other heavily indebted countries, particularly Spain and raise doubts on whether the region had seen its worst.
The euro rose to as high as $1.3119, rebounding from $1.3018 hit during early London hours which was its lowest since Jan. 7. It was last trading up 0.2 percent on the day at $1.3081.
"Ongoing uncertainty regarding the Italian vote, as markets try and understand how the (political) deadlock can be broken and if it will be broken, has driven Italian assets and the euro lower," said Jeremy Stretch, head of currency strategy at CIBC.
"We have seen a cautious bounce (in the euro) but it doesn't look like we are seeing anything durable here and the risk is that the euro's performance remains relatively compromised."
Against the yen, the euro was up 0.4 percent at 120.39 yen, but not far from a one-month low of 118.74 yen struck on Monday when it posted its single biggest percentage loss since early May 2011.
Traders said the main buyer of the pair was a U.S. bank and cited stop-loss orders above $1.3120, close to its 100-day moving average of $1.3123, which was likely to cap gains.
Strategists at Morgan Stanley said they would look to close long euro/dollar positions on any rebounds into the $1.3150 area and "await clarification/stabilisation of the political picture in Italy before re-entering bullish euro strategies."
The euro has steadily lost ground this month, retreating from a 15-month high against the dollar and a near three-year high against the yen.
Recent data has reminded investors that the region is still grappling with a recession as southern European countries struggle to bring down high debt levels by imposing painful austerity.
"For the euro, the focus is on the 2013 lows below $1.30 and events in Italy show that politicians are pushing back at fiscal austerity measures," said Paul Robson, currency strategist at RBS. "It is negative for the euro and until it remains below $1.3170, it will remain a sell on rallies."
Italy's political turmoil saw its stocks and government bonds fall sharply on Tuesday and also sparked a sell-off of vulnerable Spanish and Portuguese bonds.
Strategists said Italy faces a larger hurdle on Wednesday when it offers the market up to 6.5 billion euros of 5-year and 10-year bonds, which would test foreign investors' appetite for Italian assets.
Investors' focus will also be on U.S. Federal Reserve Chairman Ben Bernanke's congressional testimony at 1500 GMT.
Markets would be looking for hints on further policy moves after some within the Fed have voiced concerns about how long it should keep buying Treasury bonds to support the economy.
The Fed chief is expected to strike a dovish note, and that could see the dollar pare some of its recent gains.
The dollar was up 0.2 percent against the yen at 91.98 yen, having tumbled to as low as 90.85 yen, its lowest in nearly a month on Monday.
While expectations of more monetary easing by the Bank of Japan could pressure the yen, the Japanese currency could remain supported at the expense of growth-linked currencies if risk appetite abates further.