Italian auction may prove obstacle for euro

An Italian flag waves in front of the Montecitorio palace before the start of a finances vote in downtown Rome November 8, 2011.

NEW YORK (Reuters) - Persistent worries about Europe's debt crisis kept the euro near an 11-month low on Tuesday, and traders said it may face more selling if Italy struggles to raise money at this week's year-end debt auction.

Trading was quiet, with UK markets closed and U.S. dealers more thinly staffed than usual, making for only slender moves in most major currency pairs.

But when the calendar turns to 2012 next week, returning investors expect the new year to start much the way the old one ended -- with a focus on Europe.

Italy's three- and 10-year bond auction on Thursday may set the tone. Rome's borrowing costs have surged in recent months. Some fear if that persists, Italy may need an emergency bailout, which would renew doubts about the euro's future.

"The upcoming year is shaping up as a do-or-die year for the euro," said Boris Schlossberg, director of research at GFT Forex in Jersey City. "The question on most traders' minds isn't whether the euro/dollar will rise or fall, but whether it will actually survive the year intact."

The euro was 0.1 percent firmer at $1.3071, and traders said gains were limited by options expiries at $1.3100 later in the day. A fall below $1.2945 -- a level touched earlier this month -- would be its worst showing since January.

Italian yields rose Tuesday ahead of the auction, and investors were worried that thin trading would make it even harder than usual for Italy to raise money.

"It will be a good barometer for market demand, and any hiccups there could be a catalyst that sees the euro break below its current range" in the low $1.30s, said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange in Washington.

"The concern is the thin markets and the long maturity of the debt on offer might make it a tough sell," he said.

Elsewhere, the dollar was down 0.2 percent at 77.84 yen and had shed about 4 percent against the Japanese currency since the year began.

Natural and nuclear disasters in Japan in March and worries about the world economy spurred Japanese investors to repatriate funds for safekeeping, supporting the yen for most of the year.

Sterling rose 0.2 percent Tuesday to $1.5661.

The U.S. economy has shown signs of improvement in the fourth quarter, with December consumer confidence hitting an eight-month high, according to data released on Tuesday.

Still, the chance of more Federal Reserve easing remains a consideration for markets.

TOUGH TRADING

The euro is down only 2.3 percent against the dollar since the year began -- speculation that the Fed may resort to more quantitative easing is partly responsible for that.

But the slight losses belie just how difficult and volatile a year it's been for currency traders. In May, the euro climbed as high as $1.4939 but shed those gains in subsequent months as a crisis that began in Greece and Ireland spread to bigger, core economies such as Italy and Spain.

Even France and Germany may now be at risk of losing their top AAA credit ratings, and strategists said any move by a major ratings agencies in that direction would knock the euro lower.

"It has been a tough market," said Alan Wilde, head of fixed-income and currency trading at Baring Asset Management, with about $50 billion (31 billion pounds) in assets. "Shorting euros would probably not have been a very rewarding trade until the last month or so."

Since then, though, bets against the euro have skyrocketed. Commodity Futures Trading Commission data showed euro "shorts" near record highs in the last week.

If the Italian sale goes smoothly, the euro may be able to hold ground above $1.30, traders said, if only because speculators are already positioned so heavily against it.

Analysts at Citigroup said this reflected a bias among investors to shun the euro and other currencies perceived to be higher risk as 2011 winds down.

In a note, they said this would keep trade subdued in the last trading days of the year, in contrast to some other years when currency movements, particularly versus the dollar, have become volatile as investors close positions at the last minute.

(Additional reporting by Naomi Tajitsu in London; Editing by Jan Paschal)