* Italy election results raise fear of political gridlock
* Euro eyes drop below $1.30
* Options show renewed weakness for euro
By Anirban Nag
LONDON, Feb 26 The euro fell to a seven-week low
against the dollar on Tuesday as fears mount about political
gridlock in Italy that could stall economic reforms there and
sour the outlook for the wider euro zone.
The common currency later recovered its losses, but with the
cost of insuring against a debt default by Italy and its bond
yields rising, traders said any bounce could prove fleeting and
that the euro could fall below $1.30 soon.
A deadlocked parliament in Italy, the euro zone's third
largest economy, could reignite fears about other heavily
indebted countries, particularly Spain. That could reverse the
optimism that the worst of the region's crisis is over, which
has boosted the euro this year.
In early London trade, the euro fell to $1.3018, its
lowest since Jan. 7, and not far from $1.2998, its 2013 low
struck on Jan. 4. It recovered to trade at $1.3065 on steady
buying by a U.S. bank, but traders said liquidity was thin and
gains are likely to be capped.
Against the yen, the euro was up 0.1 percent at
120.07 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.
The single currency 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."
Since the summer of 2012, the euro has also benefited from
the European Central Bank's pledge to buy bonds of struggling
member countries which ask for help.
Some analysts say if weaker economies' bond yields rise
sharply due to prolonged uncertainty stemming from the Italian
election, pressure could build on the ECB to act on its promise
and buy debt to keep a lid on borrowing costs.
Reflecting some of that nervousness, the options market
showed investors were expecting sharper moves in the euro in the
near term. The one-week euro/dollar implied volatility
- a measure of future price swings - jumped to 13.5
percent from 10.5 late on Monday.
The benchmark one-month risk reversal was
dealt at 1.5 vols in favour of euro puts - bets that the
currency will fall - up from around 0.8 on Monday.
DOLLAR AWAITS BERNANKE
Investors' focus will also be on U.S. Federal Reserve chief
Ben Bernanke's congressional testimony at 1500 GMT, with some
rattled by debate within the Fed about how long it should keep
buying Treasury bonds to support the economy.
The Fed chief is likely to strike a dovish note, and that
could see the dollar pare some of its recent gains.
The dollar was up 0.1 percent against the yen at
91.90 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.
In addition to the Italian gridlock, a U.S. stalemate over
spending cuts that threaten the economic recovery undermined
sentiment. President Barack Obama and Congress remain deadlocked
over how to prevent $85 billion in automatic government spending
cuts set to start on March 1.
Analysts said bets against the yen have grown at a steady
pace making the pair ripe for a pullback.
"The yen was long overdue for a correction..... (its)
downtrend may have run its course for the time being," said
Teppei Ino, currency strategist at the Bank of Tokyo-Mitsubishi