* Euro dips after Monti says will quit once budget passed * ECB rate cut prospects hurt euro * Italian turmoil threatens contagion effect on Spain * Fed meeting on Wednesday significant for dollar By Gertrude Chavez-Dreyfuss NEW YORK, Dec 10 The euro fell against the yen and was flat versus the dollar on Monday after Italy's Prime Minister said he would step down early, putting the country's outlook in a state of flux and raising concerns about the euro zone's near-term prospects. Mario Monti said on Saturday he would resign once the 2013 budget passes. An election in February looks probable, with investors worried about who will navigate the euro zone's third-biggest economy out of the debt crisis The news pushed Italy's borrowing costs higher to 4.83 percent, the highest in roughly more than three weeks. Top-ranking German bonds benefited, lifting prices and pushing 10-year yields down to 1.28 percent, their lowest since early August. "The political situation in Italy just adds to the uncertainty in Europe and this will have a negative impact on the euro in the coming months," said Matthew Lifson, senior trader and analyst at Cambridge Mercantile Group in Princeton, New Jersey. The euro was down 0.3 percent on the day at 106.28 yen, falling for a third straight say. It dropped as low as 105.94, its weakest in about two weeks. Against the dollar was the euro was flat to slightly higher at $1.2931. Euro resistance remains at the $1.2940 level, said Lifson, with support at $1.2885 and $1.2860. Some analysts noted that the bond and currency markets' reaction to Italy's news may have been overdone given the fact that Monti would have called for elections in a few months time anyway. Monti's decision simply expedites the process. "Given the chaotic history of Italian politics, it is almost certain that whoever is elected Prime Minister will not be able to exercise anywhere near the level of control over the country's fiscal policy enjoyed by Mr. Monti," said Boris Schlossberg, managing director of FX strategy at BK Asset Management in New York. While Italy has nearly completed its planned bond market funding for this year, the latest political turmoil could hinder its ability to borrow around 420 billion euros in 2013. There could also be an impact on neighboring Spain whose government is studying the need for outside help. Concerns about core euro zone countries also weighed on the common currency. Germany's Bundesbank last week slashed its growth outlook for Europe's largest economy to 0.4 percent in 2013 from an early estimate of 1.6 percent. FED FOCUS Caution about possible fresh monetary easing steps from the Federal Reserve later this week limited the dollar's advance. Despite turmoil in Italy, the dollar index was just up 0.1 percent at 80.312. "People are just positioning themselves for the last decent week we could have in terms of data before getting into the Christmas period," said David Bloom, global head of FX research at HSBC. "The Fed meeting will be important." Many economists expect the Fed to announce on Wednesday monthly bond purchases of $45 billion, signaling it will keep pumping money into the economy to bring down unemployment. Signs Washington policymakers are no closer to averting tax hikes and spending cuts set to take hold next year, which analysts say could push the U.S. economy back into recession, also weighed on the dollar. The greenback fell 0.3 percent on the day to 82.20 yen as traders said macro funds cut long dollar positions. Data showed speculators' net yen short positions last week rose to their highest since mid-2007. With short bets already stretched, traders said it would be difficult for the dollar to advance against the Japanese currency. But some saw a drop in the dollar as a buying opportunity. Morgan Stanley recommended buying dollars at 82.00 yen, with a stop of 81.50 yen and a target of 84.00 yen. The bank expected a weaker yen on the prospect of further monetary easing by the Bank of Japan after a general election next Sunday. The opposition Liberal Democratic Party is expected to win and this is likely to result in more pressure on the BOJ to ease policy.