The euro rose against the dollar for the first time in three sessions on Wednesday on relief over solid demand for Italy's first bond sale since the country's general elections, but the potential for political uncertainty will likely contain any upside.
Robust demand for Italy's bonds despite a rise in the country's 10-year debt costs helped spur buying in the euro, which had fallen nearly 1.0 percent against the dollar on Monday in the wake of Italy's inconclusive elections.
Italy's borrowing costs on the 10-year debt climbed more than half a percentage point to a four-month high. Italy, the euro zone's third largest economy, is fueling renewed concern about a possible re-emergence of the euro zone debt crisis.
Doubts about Italy's ability to reform its indebted economy resurfaced after the weekend elections 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 last traded at $1.3133, up 0.6 percent on the day, but below a session high of $1.3129.
The euro also found support from a survey showing 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 held above Tuesday's low of $1.3017, which was its weakest since Jan. 7. 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 anytime 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 — toward the end of last month.
Also on Wednesday, Federal Reserve Chairman Ben Bernanke in testimony to the U.S. House of Representatives reiterated his prior day comments before the Senate that the central bank would keep buying bonds for awhile. The remarks have helped alleviate some market concerns about an early end to the Fed's easing program.
Yen Slips Back
The yen slipped against the dollar and euro, after earlier rising on Japanese fiscal year-end flows and its status as a safe-haven currency.
The U.S. dollar last traded at 92.20 yen, up 0.3 percent on the day, still below a 33-month high of 94.76 touched on Monday.
The euro stood at 121.10 yen, up 0.8 percent on the day, above Monday's one-month low of around 118.74 yen.
The yen has been one of the worst performing major currencies 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 strength will likely be temporary given demand among Japanese investors for higher-yielding foreign assets.
The British pound is also one of the worst performing currencies this year.
British government bonds rose on Wednesday after a top central banker said more gilt purchases over a longer period than before might be needed to help Britain's economy.
Elsewhere, the Swiss National Bank is far from exiting its policy of capping the strong Swiss franc, Chairman Thomas Jordan said on Wednesday, pointing to new risks from the indecisive outcome of the Italian election.
The euro last traded at 1.2204 francs, up 0.3 percent on the day, according to Reuters data.