FOREX-Euro bulls suffer as Italy stokes political uncertainty

* Single currency reverses gains after German SPD vote

* Positioning in long euro bets still near record

* Graphic: World FX rates in 2018

LONDON, March 5 (Reuters) - The euro was flat after initially weakening on Monday as an inconclusive election in Italy pointed to prolonged political uncertainty after a stronger-than-anticipated showing by right-wing eurosceptic parties.

Italy’s election verdict and the subsequent brief sell-off in currency and bond markets showed that political risks remain in the eurozone though recent strength in its economy has made investors more tolerant of related uncertainty than last year.

“Investors still believe that politics appear less likely to upset the apple cart than only a year ago and Eurozone growth could be hitting three percent this year,” said John Taylor, fixed income portfolio manager at Alliance Bernstein in London.

He noted that in the run up to the vote, Italian spreads widened much less compared to French bonds last year, despite the ECB winding down its bond purchase plan.

The euro rose to a two-week high above $1.2360 in Asian trading after Germany’s Social Democrats voted to re-enter a grand coalition with Chancellor Merkel’s conservatives, signalling an end to a period of political uncertainty in Europe’s biggest economy.

But it quickly retreated by 0.8 percent towards the day’s low at $1.2269 as results from Italy pointed to a messier than expected outcome - a strong showing for anti-establishment parties and no groupings able to form a stable government.

The euro then rebounded on the day to trade flat against the dollar and was down only 0.2 percent against the yen . It had fallen as much as 0.7 percent to 129.35 yen , its lowest since late August in early London trading.

“The protest vote gained traction, as we expected, pointing to higher uncertainty in the short term,” said Alberto Gallo, head of macro strategies at London-based fund Algebris.

Despite the bounce, the euro was within striking distance of a seven-week low of $1.21545 touched on Thursday.


More worryingly from the euro’s perspective, recent data showed that economic momentum has stalled in the euro zone, indicating the single currency may be coming under some pressure. A Citi economic surprise index for the currency bloc is at near six-month lows.

“There is some lingering caution around the outcome of the Italian election results and only the German vote prevented a bigger drop in euro/dollar,” said Viraj Patel, an FX strategist at ING in London.

Any signs the recovery in Italy’s economy could be undermined by political uncertainty could ripple through bond markets and weigh on the single currency, which hit a more than three-year high of $1.2556 in mid-February.

“Economic momentum has stalled, but it is likely to recover in the second half of the year and for these reasons we have taken profits on our long euro position against the USD at 1.25 in February,” Algebris’s Gallo said.

In an indicator of how sanguine currency markets were about any spike in Italy’s turmoil, risk reversals in currency derivatives markets for euro/dollar were smaller than before France’s election verdict in May last year.

Even latest positioning data showed euro bulls remained firmly upbeat, with net long currency positions still near touching distance of record bullish bets in early February.

“Ultimately, this is expected uncertainty, and the markets are far more tolerant about European politics than earlier given the favorable economic backdrop,” said Geoffrey Yu, head of the U.K. investment office at UBS Wealth Management in London.

The dollar was also on slippery footing after U.S. President Donald Trump last week proposed tariffs on imported steel and aluminum, raising fears of retaliation that could trigger a trade war.

The dollar was softer against the yen at 105.49 yen , near Friday’s 16-month low of 105.24.

Bank of Japan Governor Haruhiko Kuroda said the BOJ would consider an exit from its ultra-easy monetary policy if it met its inflation target in the next fiscal year from April 2019.

Reporting by Saikat Chatterjee Editing by Mark Heinrich