* Solid Italian bond sale buoys euro, but borrowing costs rise
* Fed’s Bernanke reiterates support for Fed stimulus
* Options market shows bias for euro weakness
* Yen gains in fiscal year-end flows, safe-haven status
By Julie Haviv
NEW YORK, Feb 27 (Reuters) - The euro rose against the U.S. dollar for the first time in three sessions on Wednesday as solid demand for Italy’s first bond sale since Monday’s general elections brought relief, but the potential for prolonged political uncertainty should contain the currency’s upside.
After falling nearly 1.0 percent on Monday in the wake of Italy’s inconclusive elections, investors opted to buy the euro at cheaper levels after robust demand for Italy’s bonds despite the rise in Italian 10-year debt costs which climbed more than half a percentage point.
Italy’s borrowing costs rose to their highest in four months, which could raise concerns the euro zone debt crisis could re-emerge in Italy, the euro zone’s third largest economy.
Investors continue to fret about Italy’s ability to reform its indebted economy following the weekend elections which showcased the lack of popular support for austerity policies and resulted in a hung parliament.
“The last few days have reminded the market that there is tremendous uncertainty risk in the euro zone in terms of economic growth as well as the outlook for reform,” said Camilla Sutton, chief currency strategist at Scotiabank in Toronto.
“Technical and fundamental signals still warn of euro downside ahead,” she said. “Italy’s vote warns that the path for Europe has just become more complicated.”
The euro was trading around at $1.3078 midsession on Wednesday, up 0.1 percent on the day, but below a session high of $1.3122 hit after a survey showed euro zone economic and business confidence improved for a fourth straight month in February.
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.
The euro, however, held above Tuesday’s low of $1.3017, 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.”
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 put options - bets the currency will weaken. Risk reversals had flipped to euro calls - bets it will rise - towards the end of last month.
Meanwhile, Federal Reserve Chairman Ben Bernanke on Wednesday reiterated comments from the previous day, 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 program.
UBS’s chief currency strategist, Mansoor Mohi-uddin said that while Bernanke is still “dovish” on policy, a likely improvement in the U.S. economy would set the stage for the Fed to reduce 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 Japanese fiscal year-end flows and its status as a safe-haven currency as investors fret about the political situation in Italy.
The U.S. dollar last traded at 91.24, down 0.8 percent on the day, but above a one-month low of 90.92 touched on Monday. The dollar also hit a 33-month high of 94.76 yen on Monday.
The euro stood at 119.42, down 0.6 percent on the day, but holding above Monday’s one-month low of 118.74 yen.
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.
Strategists said the yen’s current strength will likely be temporary 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.