Market LookBeck II

(Reuters) - The euro rallied against the U.S. dollar on Wednesday, reversing a drop to a near three-week low earlier in the day, as optimism that Italy can resolve its political gridlock offset weak German data.

The euro had fallen after a survey by Germany's Ifo think-tank showed business sentiment dropped for a second month in April, fueling concerns about the health of the euro zone's largest economy and fanning speculation that the European Central Bank will cut rates soon.

The euro was already vulnerable after German purchasing managers' index data on Tuesday showed business activity dropping sharply in April.

"The release of softer IFO data from Germany drove a brief decline in the euro, albeit one that was quickly retraced," said Eric Theoret, forex strategist at Scotiabank in Toronto.

The euro dropped to $1.2954, its lowest since April 5, before recovering to trade at $1.3019, up 0.2 percent. An Asian central bank and a supra-national investor were cited as buyers earlier in the global trading day.

"With regards to the outlook for the ECB, focus has turned to next Thursday's meeting, with rising expectations for an easing in monetary policy," Theoret said.

The European Central Bank currently has rates at a record low 0.75 percent.

Recent comments by ECB policymakers have stressed declining inflation and poor euro-zone growth prospects, suggesting policymakers are leaning toward a further cut at their next meeting on May 2. The ECB has room to act on interest rates if economic conditions remain weak, ECB Vice President Vitor Constancio said on Wednesday.

With interest rates in the United States and Japan at or near zero, an ECB rate cut would diminish the euro's advantage. The ECB, however, has refrained from pumping massive amounts of money into the euro zone through asset purchases, unlike the Federal Reserve or the Bank of Japan's actions.

And investors may view an ECB rate cut as positive for the euro because the central bank is taking action to stimulate economic growth.

Traders said the euro drew some support from reports that Italian President Giorgio Napolitano had called on Enrico Letta, deputy head of the centre-left Democratic Party, to form a new coalition government.

The formation of a government in the euro zone's third-largest economy after months of uncertainty would offer relief to investors looking to buy assets in the region.

"But the risk-reward in the euro is to sell it into any rise to $1.3100/50," said Mankash Jain, head of foreign exchange and investment management at hedge fund Solo Capital in London. "The data from Germany has been weak, the Ifo was weak, and if the ECB were to cut rates next week, the euro would fall."

DOLLAR WEIGHED BY WEAK U.S. DATA

The U.S. dollar was little changed against against the yen in a volatile session after data showed orders for long-lasting U.S. manufactured goods, known as durable goods, recorded their biggest drop in seven months in March and a gauge of planned business spending rose modestly, adding to signs of a slowdown in factory activity.

While the yen remains weighed by the Bank of Japan's ambitious bond-buying program announced this month, concerns about global growth have lifted the currency recently.

The dollar hit a four-year high of 99.94 yen on April 11 after the Bank of Japan unveiled a sweeping monetary stimulus program that entails buying $1.4 trillion of bonds in less than two years.

The dollar last traded at 99.45 yen, little changed on the day.

Many traders are braced for a test of the 100-yen mark in coming days, although offers were reported around 99.80-85 yen that could limit the dollar's gains in the short term.

"Price action this week can be characterized as 'sideways,' best displayed by the euro/dollar's inability to shake $1.3000, or the dollar/yen's inability to break through 100 yen," said Christopher Vecchio, currency analyst at DailyFX in New York. "There's significant event risk coming up over the next week that should keep price action relatively contained until the events come to pass: the Bank of Japan meeting on Friday, the U.S. first-quarter GDP release on Friday, and the European Central Bank meeting next Thursday."

Some USD5.18 billion in euros changes hands on Wednesday,using Reuters Dealing data, compared with USD4.23 billion on Tuesday. USD2.59 billion in yen trades, compared with USD3.164 billion on Tuesday, using Reuters Dealing data.