FOREX-Euro off 7-week low vs dollar, Italy gridlock to cap gains
* Italy election results raise fear of political gridlock
* Euro eyes drop below $1.30
* Options show renewed weakness for euro
LONDON, Feb 26 (Reuters) - 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 UFJ.