An election in February looks probable, with investors worried about who will navigate the euro zone's third-biggest economy out of the debt crisis. The euro, however, gained ground after Monti tried to reassure rattled financial markets that Italy would not be left adrift following his surprise decision to resign and Silvio Berlusconi's return to frontline politics.
Some analysts noted that the bond and currency markets' reaction to Italy's news may have been overdone, given the fact that Monti would have called for elections in a few months anyway. His decision simply expedites the process. "The markets over reacted to the weekend news and so now we are seeing a pullback and somewhat of a 'risk on' climate," Sebastien Galy, FX strategist at Societe Generale in New York. "We are range trading for the most part and fading some of the euro zone risk," he said.
The euro was last flat on the day against the yen at 106.58 yen after dropping as low as 105.94 yen, its weakest point in about two weeks. Against the dollar, the euro was last up 0.4 percent at $1.2942. "Given the chaotic history of Italian politics, it is almost certain that whoever is elected prime minister will not be able to exercise anywhere near the level of control over the country's fiscal policy enjoyed by Monti," said Boris Schlossberg, managing director of FX strategy at BK Asset Management, in New York.
While Italy has nearly completed its planned bond market funding for this year, the latest political turmoil could hinder its ability to borrow around 420 billion euros in 2013. There could also be an impact on neighbouring Spain, whose government is studying the need for outside help. Concerns about core euro-zone countries also weighed on the common currency. Germany's Bundesbank last week slashed its growth outlook for Europe's largest economy.
The euro was also pressured by data showing that Germany posted its narrowest trade surplus in more than half a year in October. Caution that the US Federal Reserve may take fresh steps on monetary easing later this week limited the dollar's advance. The dollar index was down 0.1 percent at 80.338.
Many economists expect the Fed to announce on Wednesday monthly bond purchases of $45 billion, signalling it will keep pumping money into the economy to bring down unemployment. That should be bearish for the dollar in general. Bob Lynch, global head of FX strategy at HSBC in New York, said the Fed's likely announcement of further asset purchases on Wednesday may not overly pressure the dollar as the market has already factored it in, but over the longer term, the negative effect would be more pronounced.
The Bank of Japan will probably ease monetary policy next week, sources say, as looming risks such as the potential fallout from the US fiscal cliff and slow Chinese growth continue to cloud the outlook for an economy already seen as in recession. The dollar last traded up 0.1 percent at 82.38 yen, according to Reuters data.