NEW YORK (Reuters) - The euro rose against the dollar and yen on Monday after Italy finally formed a government, ending two months of political uncertainty, but further gains may be limited given expectations the European Central Bank will cut interest rates this week.
Italy's new prime minister, centre-left politician Enrico Letta, named a coalition government on Saturday, a move that drove Italian stocks higher and benchmark borrowing costs to their lowest level since October 2010 at an auction on Monday.
Some analysts say the euro could weaken should the ECB cut its main interest rate by 25 basis points from 0.75 percent currently when it meets on Thursday; a rate cut would erode the euro's interest rate advantage over the dollar and yen.
"The euro would likely weaken somewhat on that, but the overall move will be muted," said John Doyle, currency strategist at Tempus Consulting in Washington, D.C. "The expectation is starting to get priced in."
Boris Schlossberg, managing director of FX Strategy at BK Asset Management in New York, said the euro could even rally after a knee-jerk move lower as some investors see a rate cut by the ECB as another effort to stimulate the euro zone economy.
"It's clear that the euro zone economy is really in a quagmire and it needs some kind of jumpstart," Schlossberg said. "There's almost nothing else available. A rate cut is better than nothing."
"Even though the market initially perceives the rate cut as a negative thing, it will actually be disappointed if they don't see the rate cut and that can drive the euro down."
Signs are growing that weakness in peripheral euro zone economies is spreading to the region's core, such as Germany, its biggest economy. Confidence in the euro zone economy fell more than expected in April, data showed on Monday, highlighting the souring mood among companies and consumers since March.
A drop in German inflation also contributed to the ECB rate cut argument, although the impact on the euro will likely be limited.
The euro was up 0.54 percent at $1.3096, with hedge funds cited among key buyers. It peaked at $1.3115, the highest since April 19, midway through the London session.
The U.S. economy grew more slowly than expected in the first quarter, and with inflation anchored, expectations are fading that the Federal Reserve could cut back its quantitative easing program anytime soon.
"That is weighing on the dollar," said Ian Gunner, portfolio manager at Altana Hard Currency Fund In London.
Gunner said only a cut in the ECB's zero percent deposit rate, which he did not expect, would cause the euro to fall sharply.
A two-day Federal Reserve policy meeting beginning on Tuesday will be watched for whether the Fed indicates any fresh risks to growth. If it does, there could be some trimming of long dollar positions put in place in recent months.
The dollar fell late in the New York session against the yen, down 0.33 percent at 97.71 yen. The euro gained 0.16 percent to rise to 127.98 yen.
The dollar set a four-year high of 99.94 yen earlier in April after the Bank of Japan unveiled a major stimulus program.
The dollar has faced stiff resistance at 100 yen, but many expect it to firm against the yen as Japanese investors such as insurance companies and pension funds allocate some of their portfolios to overseas assets in coming months.
Japan on Tuesday will report March economic data on unemployment, industrial production and retail sales.
"The long-term trend of yen selling is likely to be intact. We are seeing a reversal today based on the fact that Japanese investors have not responded so far to moving money abroad," said Eric Viloria, senior currency strategist at Forex.com.
"If the data are positive or stronger than expected, the yen could get a boost from that," he said, noting the 97.75 dollar/yen level as proven support.