* Euro rises from 7-week low as buyers emerge on dips
* But gains limited as Italy political gridlock weighs
* Dollar extends losses after U.S. home price data
* Bernanke's testimony at 1500 GMT
By Julie Haviv
NEW YORK, Feb 26 (Reuters) - The euro rebounded from a seven-week low against the dollar on Tuesday as investors opted to buy at cheaper levels, but gains could prove fleeting should political deadlock in Italy cause wider problems.
An electoral stalemate in Italy, the euro zone's third-largest economy, could leave its economic reform efforts in tatters and reignite the euro zone's broader debt crisis.
It could also reignite fears about other heavily indebted countries, particularly Spain, and raise doubts on whether the region had seen its worst.
"Ongoing uncertainty regarding the Italian vote, as markets try to understand how the (political) deadlock can be broken and if it will be broken, has driven Italian assets and the euro lower," said Jeremy Stretch, head of currency strategy at CIBC.
"We have seen a cautious bounce (in the euro) but it doesn't look like we are seeing anything durable here and the risk is that the euro's performance remains relatively compromised."
The euro rose to as high as $1.3118, rebounding from $1.3017 hit during early London hours which was its lowest since Jan. 7. It last traded up 0.2 percent on the day at $1.3094.
Traders said the main buyer of the pair was a U.S. bank and cited stop-loss orders above $1.3120, close to its 100-day moving average of $1.3123, which was likely to cap gains.
Against the yen, the euro was up 0.6 percent at 120.58 yen, above a one-month low of 118.74 yen struck on Monday when it posted its single biggest percentage loss since early May 2011.
The euro has steadily lost ground this month, retreating from a 15-month high against the dollar and a near three-year high against the yen.
That is a swift turnaround from the start of 2013 when the euro rallied on hopes the worst of the euro zone debt crisis was over.
Recent data, however, has reminded investors that the region is still grappling with a recession as southern European countries struggle to bring down high debt levels by imposing painful austerity.
"For the euro, the focus is on the 2013 lows below $1.30 and events in Italy show that politicians are pushing back at fiscal austerity measures," said Paul Robson, currency strategist at RBS (LSE: RBS.L - news) . "It is negative for the euro and until it remains below $1.3170, it will remain a sell on rallies."
Italy's political turmoil saw its stocks and government bonds fall sharply on Tuesday and also sparked a sell-off of vulnerable Spanish and Portuguese bonds.
Strategists said Italy faces a larger hurdle on Wednesday when it offers the market up to 6.5 billion euros of 5- and 10-year bonds, which would test foreign investors' appetite for Italian assets.
The euro extended gains versus the dollar after U.S. housing data raised risk appetite. U.S. single-family home prices picked up in December, closing out 2012 with the biggest yearly gain in more than six years as the housing market got back on its feet.
Investors' focus will also be on Federal Reserve Chairman Ben Bernanke's congressional testimony at 1500 GMT.
Bernanke faces the first of two days of congressional testimony that will subject the Fed's controversial bond-buying program to tough scrutiny and gauge his confidence in the resilience of the U.S. economy.
Lawmakers in both chambers will seek his comment on the likely impact of $85 billion in across-the-board government spending cuts that are set to take effect on March 1.
Markets will be looking for hints on further policy moves after some within the Fed have voiced concerns about how long it should keep buying Treasury and mortgage-backed bonds, called quantitative easing, to support the economy.
"Although markets have speculated that the Fed will begin to curtail its QE buying program sometime in the foreseeable future which would be positive for the dollar, we doubt that Bernanke will communicate that message today," said Boris Schlossberg, managing director of FX strategy at BK Asset Management in New York.
"Bernanke is a well-known dove on the FOMC and, given the fresh credit risks out of Europe, we believe his impulse will be to remain accommodative for now," he said.
The dollar last traded at 91.98 yen, up 0.2 percent on the day after having tumbled to as low as 90.92 yen on Monday, its lowest in nearly a month.
While expectations of more monetary easing by the Bank of Japan could pressure the yen, the Japanese currency could remain supported at the expense of growth-linked currencies if risk appetite abates further.