Euro holds near lows, vulnerable to Italy and U.S. cuts

LONDON (Reuters) - The euro neared a seven-week low against the dollar on Friday as concerns about political uncertainty in Italy outweighed better-than-expected Spanish manufacturing data.

The impending risk of U.S. government spending cuts and some speculation the European Central Bank may cut interest rates at a policy meeting next week also curbed demand for the single currency.

The euro hit a session low of $1.3046, paring earlier gains to last trade down 0.1 percent on the day.

It retreated from a session high of $1.3101 hit after Spanish data showing manufacturing shrank at its slowest rate in 20 months in February.

The single currency posted its largest monthly fall against the dollar in nine months in February, and hit a seven-week low of $1.3018 on Tuesday after an inconclusive Italian election.

Despite the risk of stalled economic reforms and rising borrowing costs in Italy, many analysts said the euro was likely to hold above $1.30 given cautious optimism politicians will reach a compromise to form a government.

Many investors are also still confident the ECB will step in and buy bonds if the situation worsens.

"We are recommending clients to cautiously scale in long euro/dollar positions at this level. But we should not fool ourselves, this (Italian situation) could still go really bad," said Arne Lohmann Rasmussen, head of FX research at Danske Bank in Copenhagen.

Traders said benign euro zone inflation data on Thursday would give the ECB room to cut interest rates, which further diminished the allure of the euro.

"It keeps a load on the euro, although you have to remember on the other side the Fed does not seem to be in any rush to exit the QE program," Danske's Rasmussen said.

U.S. Federal Reserve Chairman Ben Bernanke, in testimony to lawmakers this week, soothed some market concerns about an early end to the Fed's easing program.

Investors were also focused on $85 billion in U.S. budget cuts that are due to start on Friday, with a last-ditch deal to avert the cuts seen as highly unlikely.

Some strategists said concerns about the impact on the world's largest economy could prompt nervous investors to buy the highly liquid dollar as a safe haven.

The International Monetary Fund said it would probably cut its U.S. and global growth forecasts if those automatic spending cuts take effect on Friday, and warned that the U.S.'s biggest trading partners would be hardest hit.

The dollar index <.DXY> rose to a six-month high of 82.058.

CHINA COOLS

China's factory growth cooled in February, underlining the patchiness of the country's economic recovery.

Analysts said the data had limited impact on the euro given the focus on developments in Italy.

"The Chinese data wasn't as good as some had expected, and while usually risk-off sentiment doesn't help the euro, it didn't prove to be a major factor in Asia," said Ayako Sera, market economist at Sumitomo Mitsui Trust Bank in Tokyo.

"Sentiment toward the euro is calmer but the situation is still unclear in Italy, and investors are waiting for fresh developments there," she added.

Against the yen, the euro rose 0.2 percent to 121.04 yen. The dollar edged up 0.1 percent to 92.65 yen.

The yen, usually bought in times of heightened market stress, continued to underperform a day after Prime Minister Shinzo Abe nominated an advocate of aggressive policy action to head the Bank of Japan.

(Additional reporting by Lisa Twaronite and Ian Chua, editing by Nigel Stephenson)