By Tommy Wilkes
LONDON (Reuters) - The euro fell towards a five-month low on Thursday as investors fretted about the demands of populist parties likely to form Italy's next government and as a fresh rise in U.S. Treasury bond yields underpinned demand for the dollar.
The euro has slumped six cents from more than $1.24 in the space of three weeks after a huge dollar rally. Investors are betting that U.S. interest rates will need to rise further to curb inflation while other central banks are postponing monetary tightening.
That has forced investors who took big positions against the dollar anticipating it would fall in 2018 to rush to unwind and cover their positions, pushing the greenback even higher.
Some analysts say the market remains complacent about the possibility of a rising dollar, which also notched up a four-month high against the Japanese yen on Thursday as 10-year Treasury yields (US10YT=RR) approached their highest since 2011.
The euro slid 0.2 percent to $1.1787 (EUR=), slightly above the $1.1763 2018 low it hit on Wednesday.
"This sense of a market that is not particularly well prepared for a euro decline is supported by the benign valuations still evident in the pricing of six-month and 12-month implied volatility," BNY Mellon analysts said in a note, referring to prices of a measure of expected swings in the value of the euro.
The dollar index rose 0.1 percent to 93.502 (DXY), below its 2018 high of 93.632.
The euro is also suffering from reports Italy's anti-establishment 5-Star Movement and the anti-immigrant League, which are working to draft a coalition program, may ask the European Central Bank to forgive 250 billion euros of debt.
But broader Italian markets held up better on Thursday as investors played down the broader impact on euro zone political stability and questioned whether the Italian parties would really follow through on such plans.
"The sheer outlandishness of some leaked plans helped ease investor concerns a bit. The would-be coalition's denials that leaked draft policies were ever concrete plans also helped smooth markets," said Ken Odeluga, an analyst at City Index.
Sterling gave up earlier gains after the UK government dismissed a media report that Britain wanted to stay in the European Union's customs union after Brexit.
The dollar rose to its strongest versus the Japanese yen since Jan. 23, up 0.3 percent on the day at 110.70 yen
The Australian dollar added 0.1 percent to $0.7524
Volatile emerging market currencies, the biggest losers from the dollar's recovery, took another beating.
Rising Treasury yields have enhanced the dollar's appeal and raised global borrowing costs. For emerging markets with current account deficits that means higher costs and the risk of fund outflows and their currencies declining further, analysts say.
The Indonesian rupiah
Brazil's real
The Turkish lira