Euro Rally: Was It Just Too Good to Be True?

An inconclusive election result in Italy that raises the specter of policy deadlock in the euro zone's third largest economy, appears to have stopped a stellar euro rally and could mark a turnaround in the currency's recent good fortunes, analysts said.

The euro slumped to $1.3047 overnight, its lowest level in almost seven weeks, following early results from the voting in Italy that took place on Sunday and Monday.

Euro/Dollar 5-Day Chart

While Pier Luigi Bersani's center-left bloc has taken enough votes to give it control of the lower house of parliament, no party or likely coalition won enough seats to gain a majority in Italy's upper house, which implies a hung parliament at a time when the country urgently needs to fight a deep recession, high unemployment and a huge public debt.

Fears that uncertainty in Italy could spark a fresh euro zone crisis rattled global markets on Tuesday. This follows months of calm and increased confidence in the outlook for Europe that have helped underpin risk appetite – the euro rose above $1.37 earlier this month, its highest level in over a year.

(Read More: Global Markets Fear Italian Hung Parliament)

"We're now left in limbo and we don't know what the election result means for the reform agenda and the policies Italy needs to implement. It's not a helpful outcome at all," Paul Bloxham, chief economist for Australia at HSBC told CNBC Asia's "Squawk Box" on Tuesday. "Europe is back in the foreground and is likely to be there for a while."

The euro has been one of the best performing major currencies in recent months. It has climbed about 9 percent from a low of $1.2050 hit in July last year amid a debt crisis in Spain.

A pledge, however, by European Central Bank President Mario Draghi in July to do "whatever it takes" to prevent the euro zone from collapse reassured markets and put the currency on an upward path against the greenback.

From Good to Bad

"We shouldn't be shocked by volatility and Italian politics. Still, there was degree of complacency in markets that the polls, which had shown a Bersani- Monti coalition, would be able to gain control," said Westpac Bank's senior currency strategist Sean Callow, referring to center-left leader Pier Luigi Bersani and Mario Monti, the outgoing prime minister who leads a centrist alliance.

Attempts by Monti's government to cut spending caused widespread public anger, boosting the support of populist parties in the election. Former Prime Minister Silvio Berlsuconi's center-right gained ground in the upper house, known as the Senate.

(Read More: Italy's Former Savior Stares at Fourth Place)

In Italy, both houses of parliament have equal power in making law.

"We've really had to adjust our targets. We were hoping for a bit of a bounce on a better outcome for markets and we haven't even had the full reaction from the Italian bond markets, so we're looking at the euro to slip to the $1.28 - $1.29 area," Callow added.

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Analysts said that although steps taken by the European Central Bank and European policymakers last year, such as formally setting up a bailout fund to provide assistance to troubled member states, provided a degree of support to markets, the euro now looked poised for a period of volatility.

"At the very least, we should be in a phase that some of the money that flowed into Europe, particularly from Japan should at least pause," said Callow. "The tide is certainly changing and you would think that money might start looking elsewhere."

Will Oswald, global head of FICC Research at Standard Chartered expected the euro to slip below $1.30 in the weeks ahead and weaken to the low $1.20 area over the course of the year.

"At this point in time, it looks like there will be a second election and that's not a good place to be," Oswald told CNBC. "Volatility is coming back into markets and it's looking pretty bad."

(Read More: Bernanke Speaks as Italy Becomes New Market Headwind)

- By CNBC.Com's Dhara Ranasinghe; Follow her on Twitter @DharaCNBC