By Tom Finn
LONDON (Reuters) - The euro rallied further on Thursday as Italian parties renewed attempts to form a government, easing concerns about the wider impact of a political crisis in the euro zone's third-largest economy.
The rise of a potentially eurosceptic government in Italy and the impact that could have on the stability of Europe has seen the euro fall 3.5 percent this month amid a resurgent dollar.
A degree of calm, however, has returned with two anti-establishment parties renewing efforts to form a coalition government rather than force Italy into holding elections for the second time this year.
The euro on Thursday climbed to a three-day high of $1.1725, having risen 1.1 percent the previous day, its second-biggest daily gain so far this year. It had hit a 10-month low of $1.1510 on Tuesday.
The rally followed remarks by Italian Prime Minister-designate Carlo Cottarelli on Wednesday that possibilities had emerged "for the birth of a political government," suggesting politicians, rather than technocrats like himself, might be able to steer the country out of deadlock.
That has eased fears of fresh Italian elections, a vote some say would effectively be a referendum on Italy's euro membership.
"There's some calm now and the $1.15 level looks like a trough for the euro for the time being," said Commerzbank (DE:CBKG) analyst Thu Lan Nguyen.
"But the markets are likely to remain in thrall of the political crisis in Italy. Euro investors should therefore remain vigilant," she said.
Others also remained cautious.
"As the Italian bond spreads have shrunk, the euro is being bought back. But the situation still looks murky and it is far from certain whether the euro's recovery becomes full-fledged," said Naoya Oshikubo, strategist at Barclays (LON:BARC).
The euro is set for its biggest monthly drop in more than three years, according to Thomson Reuters data.
An underlying theme that has pushed the euro lower since mid-April is a slowdown in Europe and the subsequent retreat in expectations for an early rate hike from the European Central Bank.
Financial markets expect the ECB to wind down its 2.55 trillion-euro stimulus program by the end of this year and raise its policy interest rate towards the middle of next year.
Weaker-than-expected economic data out of the euro zone, however, has raised questions about that.
Apart from developments in Italy, investors are also looking to the upcoming euro zone consumer price data
While the calmer mood around Italy helped to knock the yen off its five-week high hit on Tuesday, many investors are also wary of a potential escalation in trade frictions.
Sources said the United States will announce plans to impose tariffs on steel and aluminum imported from the European Union, affirming a report in the Wall Street Journal.
The dollar shed 0.3 percent to 108.60 yen JPY= on Thursday morning, edging back towards Tuesday's five-week low of 108.115 yen.
The dollar index against a basket of six major currencies (DXY) was down 0.3 percent on the day at 93.833.
Against the greenback, the Canadian dollar
(This story corrects lead to say third biggest economy in euro zone, not Europe.)