* Borrowing costs rise at Italian bond auction
* Scope for euro to fall below $1.30
* Bernanke expected to reiterate support for Fed stimulus
By Anirban Nag
LONDON, Feb 27 (Reuters) - The euro rose on Wednesday on relief that Italy was able to sell bonds despite mounting political instability, though gains could be temporary with many investors looking to sell at higher levels.
At the auction there was healthy demand for bonds, but Italian 10-year debt costs climbed more than half a percentage point, raising concerns the euro zone debt crisis could re-emerge in the region's third largest economy.
The single currency fell to $1.3079 after the Italian auction from a session high of $1.3123, that was hit after a survey showed euro zone economic and business confidence improved for a fourth straight month in February.
It later recovered to trade up 0.4 percent on the day at $1.3115 although offers from sovereign investors at its 100-day moving average of $1.3125 are likely to cap gains.
The euro held above Tuesday's low of $1.3018, which was its weakest since Jan. 7, but strategists say further losses are likely as uneasy investors wait to see whether Italian politicians can form a coalition, or will call fresh elections.
"Euro weakness is going to return and I think by the end of the day we will see a drop through yesterday's lows," said Adam Myers, senior FX strategist at Credit Agricole.
"A grand coalition is not going to be announced any time soon and until we get any sign of a new election uncertainty is going to continue."
Technical strategists said there would be support for the euro at this year's low of $1.2998, and below that around the Dec. 7 low of $1.2876. That is a far cry from a 15-month high of above $1.27 struck earlier this month.
In the options market, the one-month euro/dollar risk reversals showed their highest bias for euro weakness since late June as investors bought euro puts - bets the currency will weaken. Risk reversals had flipped to euro calls - bets it will rise - towards the end of last month.
Investors were also looking ahead to U.S. Federal Reserve Chairman Ben Bernanke's testimony to the House Financial Services Committee later on Wednesday.
Bernanke is expected to reiterate comments from Tuesday, when he said the central bank would keep buying bonds for a while, helping alleviate some market concerns about an early end to the Fed's easing programme.
Bernanke's comments curbed demand for the dollar, which tends to be weakened by loose U.S. monetary policy. On the other hand, signs that the Fed may withdraw some of its monetary stimulus, as indicated by the minutes of the Fed's last policy meeting, does give the dollar a boost.
UBS's chief currency strategist, Mansoor Mohi-uddin said that while Bernanke is still dovish, a likely improvement in the U.S. economy would set the stage for the Fed to lower its asset purchase programme in the second half of the year.
"We prefer the dollar as the Fed will be withdrawing some of its unconventional policy setting," he added.
The yen edged up, benefiting from being seen as a safe-haven currency by investors nervous about the political situation in Italy and which has the potential to throw global financial markets into turmoil.
The dollar fell 0.3 percent on the day to 91.65 yen but managed to hold above a one-month low of 90.85 touched on Monday. The euro stood at 120.10, flat on the day and holding above Monday's one-month low of 118.74 yen.
Despite this week's gains, the yen has been one of the worst performing major currency so far this year as investors bet on more aggressive policies from the Bank of Japan to beat deflation, and positioned for more monetary stimulus.
The dollar hit a 33-month high of 94.77 yen on Monday.
Strategists said the yen's current rebound was likely to be short-lived given demand among Japanese investors for higher-yielding foreign assets.
"The yen weakening trend will resume because on the Japanese side of the equation the incentive to look for better returns elsewhere is still there," said Ian Stannard, head of European FX strategy at Morgan Stanley.
Morgan Stanley expects the dollar to rise towards 95 yen.