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The stunning results of the Italian elections spurred landmark movement in the currency markets, and now, with rumors swirling about a short-selling ban, Italy is the prime catalyst driving equity and currency markets worldwide.

In the wake of the turmoil of the Italian election results, which have caused Italian equities to plunge nearly 5% at the open while Italian credit spreads spiked, the Italian regulator is considering a short-selling ban. The regulator stated that the bourse will monitor exchanges and use all instruments to calm the markets.

A ban on short selling could provide temporary halt on equities, but may result in further selling of the EURUSD as speculators turn to the currency markets where no such regulation exists. The EURUSD has been on a seesaw ride in early European trade, as it absorbed wave after wave of selling but managed to remain above the psychologically important 1.3000 level for the time being.

Bargain hunting demand from the Middle East, as well as end-of-month sovereign fund flows, have acted as counterpoint to the massive speculative selling that the pair has seen so far. The EURUSD has been able to stabilize near the 1.3060 level, but if the short-selling ban goes into effect, it could once again see the selling resume as shorts turn to currencies to express their bearish view.

Italian Election Results Stun the Markets

The status quo favorite, Pier Luigi Bersani, won the lower house by less than half a point, while former premier SilvioBerlusconi came in a surprisingly strong second, winning a blocking minority in the Senate. In its first national contest, the protest candidate, Beppe Grillo, received more than 25 percent support, making him a key player in the new Italian government.

The three-way split has effectively created a stalemate, and over the next several days, Mr. Bersani will most likely attempt to create a coalition government, but few experts expect him to succeed. Furthermore, any future Italian government is unlikely to pursue the stringent austerity agenda imposed by current leader Mario Monti, as the economic toll of his policies has created a clear rebellion amongst the voters.

Italy now stands as ground zero for the Eurozone sovereign debt crisis, which could deepen over the next several weeks if the uncertainty continues to weigh on the capital markets.

Today's Italian bill auction already saw the effects of the election, as yields spiked by more than 50 basis points, rising to 1.237% from 0.731% the month prior. This was the highest yield since October, showing that the cost of financing for Italy may rise significantly this year, adding further downward pressure to an already weakened economy.

Key Testimony from Fed Chairman Bernanke on Tap

Speculators may be also positioning themselves ahead of the key testimony by Fed Chief Ben Bernanke, who will make his semi-annual appearance in front of Congress.

Although markets have speculated that the Fed will begin to curtail its quantitative easing buying program sometime in the foreseeable future, which would be positive for the dollar, we doubt that Bernanke will communicate that message today. Dr. Bernanke is a well-known dove on the FederalOpen Market Committee (FOMC), and given the fresh credit risks out of Europe, we believe his impulse will be to remain accommodative for now.

Bernanke’s testimony may provide a modicum of relief for the EURUSD, and the pair could rally above the 1.3100 level on some short-covering flows. However, once the attention turns back to Europe, the intractable stalemate in Italy could revive risk-aversion flows as the week progresses, and EURUSD would then be vulnerable to another test of the 1.3000 level as a result.

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By Boris Schlossberg of BK Asset Management