Euro saved by smooth Italy debt auction; BOJ news awaited

SYDNEY (Reuters) - The euro held its ground against the dollar and yen on Thursday, with euro bulls taking heart after a relatively smooth auction of Italian government bonds helped ease worries about the country's inconclusive election.

The common currency traded at $1.3134, having bounced from an eight-week trough of $1.3018 plumbed earlier in the week. Against the yen, the euro fetched 121.14, up from a five-week low of 120.20.

Euro longs were shaken on Monday after the February 24-25 election gave none of Italy's political parties a parliamentary majority. The outcome raised the risk of prolonged uncertainty in the euro zone's third largest-economy and a renewal of the region's financial crisis.

Despite those fears, a sale of Italian government bonds on Wednesday drew solid demand, helping soothe jitters that the political deadlock could destabilise Europe's second-biggest sovereign debt market.

Still, analysts said the euro is unlikely to climb too far as long as uncertainty in Italy persists. Highlighting the challenges ahead, two of the country's influential party leaders ruled out the most likely option to form government and avoid a new election.

"I believe there's a growing consensus that new elections will have to take place at some point in the next few months," said Christopher Vecchio, currency analyst at DailyFX.

The steadier euro, for now, saw the dollar index .DXY retreat from a six-month high of 81.948 reached earlier in the week. It was last at 81.559.

On the yen, the dollar was a tad firmer at 92.21, having found its footing after Monday's slide to 90.85. The selloff in the euro on Monday had sparked a vicious wave of short-covering in yen crosses.

Japan's prime minister is expected to nominate Asian Development Bank President Haruhiko Kuroda as BOJ governor and Kikuo Iwata, an academic, as one of the two deputy governors as early as Thursday.

News that two doves will likely lead the BOJ had prompted investors to sell the yen as they positioned for the central bank to deliver bold policies to jumpstart the world's third biggest economy.

The dollar outperformed its Japanese counterpart even after Federal Reserve Chairman Ben Bernanke again defended the central bank's forceful easing of monetary policy.

Bernanke, facing a congressional panel for a second day, also downplayed signs of internal divisions, saying the policy of quantitative easing has the support of a "significant majority" of top central bank officials.

Commodity currencies, hit this week by renewed euro zone worries, also appeared to be on the mend. The Australian dollar was at $1.0225, recovering from a slide to a four-month low at $1.0183.

The Aussie's immediate focus is investment spending data due at 0030 GMT. Any disappointment in the figures, particularly a downgrade of future spending plans, could bolster expectations for an interest rate cut and undermine the Aussie.

Markets are currently giving only a one-in-three chance of a cut at the March 5 policy meeting.

"This number will be key in setting market expectations for RBA policy, with the potential for a March or April cut becoming live," Martin Whetton, analyst at Nomura said.

(Editing by Wayne Cole)